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The association between sustainability reporting and the value

relevance of earnings

23th June, 2014

Master thesis

Author: Saiko Man (10368795) Supervisor: Mr. dr. P. Kroos

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2   The  association  between  sustainability  reporting  and  the  value  relevance  of  earnings  

Table of content

1. INTRODUCTION 3 1.1 BACKGROUND 3 1.2 RESEARCH QUESTION 6 1.3 CONTRIBUTION 7 1.4 STRUCTURE 7 2. LITERATURE REVIEW 8

2.1 INFORMATION ASYMMETRY AND DISCLOSURE 8

2.2 DISCLOSURE AND THE VALUE RELEVANCE OF EARNINGS 10

2.3 DEVELOPMENTS IN THE VALUE RELEVANCE OVER TIME 12

2.4 SUSTAINABILITY REPORTING 15

2.5 IMPACT OF SUSTAINABILITY REPORTING ON THE VALUE RELEVANCE OF EARNINGS 18

3. RESEARCH METHODOLOGY 20

3.1 SAMPLE SELECTION 20

3.2 MODEL SPECIFICATION AND VARIABLES DEFINITION 21

3.3 EARNINGS RELATION MODEL 22

3.4 VALUE RELEVANCE OF EARNINGS AND SUSTAINABILITY REPORTING 23

4. RESULTS 24

4.1 DESCRIPTIVE RESULTS 24

4.2 MAIN REGRESSION ANALYSES 26

4.3 SUPPLEMENTAL ANALYSES 29 5. CONCLUSION 31 REFERENCES 33 APPENDIX 1 37 APPENDIX 2 39 APPENDIX 3 41

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The  association  between  sustainability  reporting  and  the  value  relevance  of  earnings   3  

1. Introduction

1.1 Background

Financial reporting and disclosure is an important tool to help communicate the firm’s performance and its governance to outside investors (Healy and Palepu 2001). According to Healy and Palepu (2001), corporate disclosure is critical to enhance the functioning of the capital market. They argue that the demand for financial reporting and disclosure arises from the information asymmetry between the managers and outside investors. This agency

problem arises because investors typically do not play an active role in managing the firm. For example, once investors invest their funds into a business, the managers of the firm can use those fund to pay excessive compensation or make investments that are not in line with the interest of the investors. In addition, information asymmetry can cause problems in the investor valuation of firm performance. Fu et al. (2012) show that higher financial reporting frequency reduces the information asymmetry between the investors and the managers. Consequently, Brown and Hillegeist (2007) found that the quality of annual report is negatively associated with information asymmetry.

Information asymmetries between management and other contracting parties create demand for a measure of firm performance (see Dechow 1994). Dechow (1994) shows that earnings is a better measure of firm performance compared to cash flows, because realized cash flows suffer from timing and matching problems that cause them to be a noisy firm performance measure. This is consistent with the study of Shamki & Rahman (2012), which indicate that earnings are more important in explaining the variance in share price and return than book value. Beaver (1998) also shows that accounting earnings is an important measure for firm performance as the primary role for accounting is to improve the link between current firm value and current accounting earnings.

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4   The  association  between  sustainability  reporting  and  the  value  relevance  of  earnings   According to the study of Shamki & Rahman (2012) the term value relevance is the ability of accounting information to summarize information that affects stock values. He also shows that earnings are more important in explaining the variance in stock prices and returns than book value. However, according to the study of Francis and Schipper (1999) there are some concerns about the relevance of financial statements to investors, lenders and other creditors. The primary concerns are about the content of financial statements (the financial information is not adequately measured), timeliness of reporting (much of the information is out-dated), and the discretion from managers in financial statements (managers adapt information to pursue their own goals). Moreover, there are also concerns about macroeconomic and institutional environment (like global trends towards harmonising financial reporting, financial crisis and strengthening regulation) on financial reporting.

In the study of Hail (2013), she examines whether the balance sheet and income

statement have lost their value relevance in 30 years. She found that the loss in relevance of the income statement continues in recent years. While the overall relevance of the balance sheet remains stable, her results suggest that changes in the economy, institutional and macroeconomic environment can affect the importance of accounting information for the use of firm valuation.

Since the 1990s companies have been publishing nonfinancial performance reports along with financial reports, because social and environmental issues are becoming increasingly important within the last decades. Companies are now more concerned about what the impact of their business operations have on the environment, for example the climate change. The amount of companies that have started to publish sustainability reports have increased substantially within the last decade, especially in the larger multinational companies (see Kolk 2005). Companies who are reporting sustainability follow the guidelines of

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The  association  between  sustainability  reporting  and  the  value  relevance  of  earnings   5   sustainability agencies such as the GRI, AccountAbility or FEE. These sustainability

agencies provide guidelines to companies to increase their quality of reporting.

There are several reasons for firms to adopt sustainability reporting such as: greater awareness of broad environmental issues, improving the firm’s credibility through

transparency, and enhancing or maintaining firm reputation (Kolk 2004). Deegan & Blomquist (2006) find that due to pressure from Non-Government Organisations and

powerful stakeholders, some companies view environmental reporting as an obligation. If the firm does not comply with the needs of powerful stakeholders, it may harm their legitimacy necessary for survival.

The study of Solomon (2011) shows that powerful stakeholders are often not interested in the company’s impact on the global climate change risk, however they view it as

something that may impact their investee’s financial performance. Institutional investors as the powerful stakeholders of corporations are turning their attention to how climate change can affect their investment returns. Solomon (2011) also shows that investors are identifying the potential financial benefits from investments in green products and technologies. This is consistent with the study of Haigh (2005), which he mentioned that retail social investors are looking for more information from companies through sustainability reports. Furthermore, Berthelot et al. (2012) suggest that investors positively value sustainability reporting.

Lourenco et al. (2011), suggest that Corporate Sustainability Performance is positively associated with the financial performance of large profitable firms, which are able to signal their sustainability performance. This is consistent with Lo and Sheu (2007), which find that Corporate Sustainability in fact has an impact on market value in the U.S. non-financial firms and these sustainable firms are rewarded with higher valuations in the market place.

The study of Jones (2007) indicates that sustainability disclosure is positively associated with some aspects of firm performance such as: operating cash flow, total assets, working

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6   The  association  between  sustainability  reporting  and  the  value  relevance  of  earnings   capital to total assets, retained earnings to total assets, asset backing per share and capital expenditure relative to assets. However, they cannot draw definitive conclusions about the association between sustainability disclosure and abnormal returns.

1.2 Research question

As the relevance of financial statements can be influenced by several factors as mentioned in the previous section. Thus, it is an interesting topic to investigate; whether the relevance of financial statements can be influenced by the sustainability reports in different industries. As sustainability reporting is becoming more important over time and investors are increasing their focus on sustainability reporting, it is plausible to expect that there is an association of sustainability reporting on the relevance of financial statements. In this study I want to explore the association between sustainability reporting and the relevance of earnings, and to test whether these associations are negative or positive. In addition, I want to explore the impact of the sustainability reporting dimensions (environmental, social and economic) on the value relevance of earnings between industries.

The research question for this study is as follows:

“Is there an association between sustainability reporting and the value relevance of earnings?”

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The  association  between  sustainability  reporting  and  the  value  relevance  of  earnings   7  

1.3 Contribution

This study contributes by showing that the relevance of earnings also can be influenced by sustainability factors other than the factors mentioned in the prior studies. This study also contributes to the study of Jones (2007), which they identify whether the level of sustainable reporting is associated with market returns and financial performance. In addition, the study of Perez and Sanchez (2009) investigate the quantity of sustainability reporting in the period between 2000-2007 for the mining industry and this study extends the study of Perez and Sanchez (2009) by investigating the quantity of sustainability reporting until 2012 in different industries. As the role of accounting information for firm valuation changes over time (Hail, 2013), this study also contributes by exploring the current status of the relevance of earnings.

1.4 Structure

Section II discusses the literature review and the differences between my study and prior studies, and the hypotheses. Section III describes the research methodology and the empirical tests. Section IV discusses the results of the empirical test and the concluding remarks appear in section V.

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8   The  association  between  sustainability  reporting  and  the  value  relevance  of  earnings  

2. Literature review

2.1 information asymmetry and disclosure

The valuation function of accounting assumes that capital markets are efficient (in the semi-strong form). An efficient market is a market where the prices of securities traded on the market at all times fully reflect all information that is publicly known about those

securities. Thus, the stock prices in efficient markets can serve as a benchmark to evaluate the relevance of accounting systems. However, capital markets are not fully efficient. As Sloan (1996) shows in his study, not all information provided by the accounting system is processed efficiently and it is not immediately reflected in the security prices. As a result, investors fail to correctly identify the different properties of the accrual and cash components of earnings. Another reason that causes market inefficiency is the information asymmetry between the principals (investors) and the agents (managers). This is when the management has relevant inside information and the investors do not. According to Healy and Palepu (2001), this agency problem arises because investors typically do not play an active role in managing the firm and delegates this to the managers. Under circumstances when the interests of managers are not aligned with the investor’s, it can cause adverse selection problems (ex ante) or moral hazard problems (ex post). Adverse selection exists when managers have information that is relevant, but it is unknown by the investors and moral hazard exists when managers perform actions that is hidden from the investors. Thus, information asymmetry causes problems in the valuation of firm performance by investors and this is why we need a mechanism to communicate inside information to the investors.

Accounting is a form of mechanism that can enable the communication of relevant information from inside the firm to outside investors. It can help in the reduction of inefficiencies in capital markets.

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The  association  between  sustainability  reporting  and  the  value  relevance  of  earnings   9   The objective of accounting is:

“ To provide financial information about the reporting entity that is useful to present and potential equity investors, lenders and other creditors in making decisions in their capacity as capital providers”.

(Conceptual Framework for financial reporting (IASB))

Fu et al. (2012) examine the impact of financial reporting frequency on information asymmetry. They find that higher financial reporting frequency reduces the information asymmetry between the investors and the managers, because higher reporting frequency increases the amount of information provided to investors and leads to a lower level of information asymmetry. This is consistent with the study of Petersen et al. (2006) where they find that disclosing more information will lower the information asymmetry between

managers and investors. They also examine the voluntary disclosure effect and find that voluntary disclosure is negatively associated with the proxies for information asymmetry.

Brown and Hillegeist (2007) examine the mechanisms through which disclosure quality is expected to reduce information asymmetry. They find that the overall quality of a firm’s disclosure is negatively associated with the average level of information asymmetry. This relation is stronger in settings characterized by high levels of firm-investor asymmetry. They also suggest that high quality disclosures reduce the incentives to search for private

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10   The  association  between  sustainability  reporting  and  the  value  relevance  of  earnings  

2.2 Disclosure and the value relevance of earnings

In the study of Barth et al. (2000) value relevance is defined as the association between accounting amounts and security market values. Holthausen and Watts (2001) describe value relevance as the empirical relation between stock market values (or changes in values) and particular accounting numbers. Another definition from Francis and Schipper (1999), where they measure relevance as the total return that could be earned from foreknowledge of

financial statement information, and the ability of earnings to explain annual market-adjusted returns.

Francis et al. (2004) investigate the relation between the cost of equity capital and seven attributes of earnings. Under the market-based attributes that are typically based on relations between market data and accounting data, they find that the attribute of value relevance dominates timeliness and conservatism. They refer earnings quality, persistence, predictability and smoothness as accounting-based attributes. Firms with the most favourable values of each attribute will enjoy lower costs of capital than firms with the least favourable values. The value relevance attribute has strong conditional effects on the cost of equity capital.

According to Barth et al. (2000) value relevance is important to a broad constituency, standard setters, firm managers, financial statement users and other policy makers and regulators such as the SEC (Securities and Exchange Commission and the Federal Reserve Board. For example, value relevance is of interest to FASB because it can provide insight into relevance and reliability of financial statement amounts, used for choosing among accounting alternatives. Financial statement users are interested in value relevance studies, because it may be capable of making a difference to decisions. Investors represent a large group of financial statement users and relevance amounts can help them assess the value of the firm.

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The  association  between  sustainability  reporting  and  the  value  relevance  of  earnings   11   According to Dechow (1994), earnings are more strongly associated with market

returns than cash flows over short measurement and in firms experiencing large changes in their working capital requirements, because under these conditions, cash flows have more timing and matching problems than earnings. This is consistent with the findings of Shamki and Rahman (2012), which show that the value relevance of earnings has increased while the value relevance of book value has decreased. Furthermore, earnings are more important in explaining the variance in share price and return than the book value.

Bepari et al. (2012) investigated the incremental value relevance of cash flow of operations (CFO) and earnings during the global financial crisis and the pre-crises period. They suggest that earnings are better in explaining the variations in share prices than CFO in the Australian market during both the global financial crisis and the pre-crisis period. This is supported by the notion that earnings contain the most value relevant information compared to the other six alternative performance measures in explaining security returns.

Bhattacharya et al. (2013) report that poor earnings quality is significantly associated with higher information asymmetry because of the adverse selection problem. The impact of earnings quality on the information asymmetry is affected by the information environment of the firm and is more present for firms with impoverished disclosure environment. They also find that information asymmetry increases around earnings releases and that these increases in information asymmetry for firms with poor earnings quality are likely to be small, because these firms already possess a high level of information asymmetry. Thus, earnings quality is associated with both the level of information asymmetry during non-earnings release periods and an increase of information asymmetry in earnings release periods. Consistent with Bhattacharya et al (2013), Lee et al. (1993) find that information asymmetry risk increases before earnings releases. They find that specialists and other liquidity providers actively manage information asymmetry risks by adjusting both spreads and depths. The combination

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12   The  association  between  sustainability  reporting  and  the  value  relevance  of  earnings   of spreads and depths are lower before the earnings announcements. Spreads and depths are both important dimensions of market liquidity and are important to specialists in the

management of information asymmetry costs. For example, if the specialist discovers that some traders possess private information, he may respond by increasing the bid-ask spread. Therefore, greater information asymmetry between informed traders and liquidity traders (trade for reasons other than private information) will lead to a wider spread.

According to Amir and Lev (1996) on a stand-alone basis, financial information (earning, book values and cash flows) is irrelevant for security valuation of independent cellular companies. These companies invest heavily in intangibles (such as R&D, customer-base and brand development) and such investments are either immediately expensed or arbitrarily amortized. Financial variables such as earnings and book values are often negative or excessively depressed and are unrelated to market values. They suggest that the value relevance of nonfinancial information overwhelms that of financial indicators. However, when combining nonfinancial information with financial information (such as earnings) after adjustments are made for the excessive expensing of intangibles, earnings do contribute to the explanation of prices.

2.3 Developments in the value relevance over time

Several studies find that the value relevance changes over time with distinction among the value relevance of earnings and book value. The study of Shamki and Rahman (2012) examines the value relevance of earnings and the book value of equity relative to the return model. He shows that the value relevance of earnings has increased while the value relevance of book value has declined in the period of 1992 to 2002. This is consistent with the findings of Bepari et al. (2013) where they examine the changes in value relevance of earnings and cash flow during the period of the crisis and the pre-crisis. They find that the value relevance

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The  association  between  sustainability  reporting  and  the  value  relevance  of  earnings   13   of earnings increased whereas the value relevance of cash flow decreased during the global

financial crisis compared to the pre-crisis period.

In contrast with these results, Collins and Maydew (1997) investigated the changes in the value relevance of earnings and book value over time. They find that the combined value of earnings and book value has not declined over the past forty years. However, earnings have declined and have been replaced by the increasing value relevance of book values. This is consistent with the finding of Francis and Schipper (1999) where they document that the income statement has lost its relevance over time. In contrast, the explanatory power of the book values of asset and liabilities provides no evidence in explaining the decline of market equity values. In the recent study of Hail (2013) she finds that the loss in relevance of financial statements still remain an issue up till today and is particularly visible in countries with a strong institution while the relevance of the balance sheet remains stable in common law countries with strong investor protection, strict disclosure requirements and integrated markets. The loss in relevance of the financial statement is not just limited to a few countries but is present in a large international sample with a strong institutional background such as; the recent changes in the accounting standards. In addition, the general economic

environment such as globalisation and market integration seem to have reduced the usefulness of earnings numbers.

The reason that the value relevance of earnings has increased in Shamki and Rahman (2012) is because earnings are more important in explaining the variance in share price and return than book value. One explanation of Bepari et al. (2013) is that during the global crisis managers are more likely to apply real earnings management with implications for cash flows, to report the desired accounting number. During the global financial crisis real earnings management dominates accounting based earnings management because, auditors

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14   The  association  between  sustainability  reporting  and  the  value  relevance  of  earnings   and regulators are more cautious to the GAAP/International Financial Accounting Standards and real earnings management cannot be questioned by auditors and regulators. Another explanation of the increase in the value relevance of earnings is that earnings timely reflect firm performance. Assets are likely to decline during the global financial crisis compared to the pre-crisis period and earnings reflect more closely the changes in the security prices than cash flows. This is consistent with Dechow (1994), who stated that cash flows suffer from timing and matching problems.

In contrast, the study of Collins and Maydew (1997) show that the shift from earnings to book values can be explained by the increasing frequency of negative earnings and

changes in the average of firm size and intangible intensity across time. Another explanation from Francis and Schipper (1999) why the financial statement has lost its relevance is because accounting standards and practices have remained stagnant while the business has changed over time or because the accounting standard have changed in a diverge way from providing value-relevant information. For example, there is a content issue of the financial statements. Financial statements do not reflect information-age assets, such as information of capacity for innovation and human resources. As a consequence, the information in the financial statement does not fully reflect the financial position of the company.

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2.4 Sustainability reporting

Sustainability reporting is a type of reporting related to the social and environmental aspects of business. According to the Global Reporting Initiatives (GRI) the definition of sustainable development is to “meet the needs of the present without compromising the ability of future generation to meet their own needs”. Reporting on the social and environmental aspect received its managerial interest in the 1970s. In the US and Western Europe, some companies adopted social reporting and accounting to monitor the social and economic effects of a company on society. This phenomenon lasted less than a decade and soon social reporting lost its momentum. In the late 1980s, reporting on non-financial issues re-emerged with a more in depth focus on environmental reporting. Companies had to report on their

environmental issues due to the pressure received by Non-governmental organizations. For example, in the study of Deegan and Blomquist (2005), the mining industry views

environmental reporting as an obligation due to pressures from WWF. Most of the mining companies believed that WWF represents the concerns of the wider community and if they do not adhere to them, it can harm their legitimacy. This suggests that the mining industry views WWF as an important stakeholder that can influence the activities necessary for their survival. Since then, sustainability reporting has grown substantially in a separated form along with financial statements. Sustainability increased from 13% in 1993 to 41% in 2005.

According to Kolk (2004), companies can have a range of reasons for publishing or not publishing a sustainability report. Table 1. lists various reasons in which reporters and non-reporters were interviewed. Reasons can be internal, company specific reasons or it can be due to societal aspects such as credibility and reputation.

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16   The  association  between  sustainability  reporting  and  the  value  relevance  of  earnings   Table 1. Companies motivations for sustainability reporting and non reporting

Reasons for reporting:

- enhancing ability to track progress against specific targets - facilitating the implementation of the environmental strategy

- greater awareness of broad environmental issues throughout the organisation - ability to clearly convey the corporate message internally and externally - improved all-round credibility from greater transparency

- ability to communicate efforts and standards - licence to operate and campaign

- reputational benefits, cost savings identification, increased efficiency, enhance business development opportunities and enhanced staff morale

Reasons for not reporting:

- doubts about the advantages it would bring to the organisation - competitors are neither publishing reports

- customer (and the general public) are not interested in it, it will not increase sales - the company already has a good reputation for its environmental performance - there are many other ways of communicating about environmental issues - it is difficult to gather consistent data from all operations and to select correct

indicators

- it could damage the reputation of the company, have legal implications or wake up sleeping dog (such as environmental organisations)

(From Kolk 2004)

Companies who are reporting on sustainability should follow the guidelines of sustainability agencies such as the Global Reporting Initiative (GRI), AccountAbility or Foundation for Environmental Education (FEE). These agencies promote the use of sustainability reporting and enhance the quality of sustainability reporting.

According to GRI, there are three dimensions of sustainability; economic, environmental and social dimensions.

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The  association  between  sustainability  reporting  and  the  value  relevance  of  earnings   17   Figure 1. The sustainability dimensions

The GRI defines the economic dimension as “ an organisation’s impacts on the economic circumstances of its stakeholders and on economic systems at the local, national and global levels. It is concerned with the impact of businesses on the economic system. According to Labuschagne et al (2007), there are some criteria in evaluating the financial stability of the company such as the economic growth, profit and research and development.

The environmental dimension deals with the impact of the organisation’s business on living and non-living nature systems including natural resources such as water resources, air resources, land resources and mineral and energy resources. It also deals with the emissions of pollution (CO2), effluents and waste. Moreover, it covers the performance of

environmental management, for example whether a company is environmentally compliant and it also looks at the environmental expenditures and the impact of the company’s products and services.

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18   The  association  between  sustainability  reporting  and  the  value  relevance  of  earnings   The social dimension discusses the impact of the organisation’s business on the social system in which it operates. It covers the social aspects such as the standard of living, education of employees, the community and providing equal opportunities for all employees.

2.5 Impact of sustainability reporting on the value relevance of earnings

In the study of Jones et al (2007), they investigate the relationship between sustainability disclosure and abnormal returns and financial performance. No association between sustainability disclosure and abnormal returns were found, however, they did find a strong statistical relationship between sustainability disclosure and some financial performance indicators. Sustainability disclosure is positively associated with the firm’s levels of retained earnings to total assets, operating cash flow to total assets and working capital to total assets. Furthermore, they find that firms with higher sustainability disclosures are relatively better priced (or conservatively valued) compared with other firms. This is consistent with the study of Gray et al. (2001) where they find that social and environmental disclosures are related to the characteristics of the firm such as firm size, firm profit and the industry affiliation of the firm. On the other hand, they were unable to find any stable relationship between any of the social and environmental measures of disclosure and corporate characteristics. The reason for this is because the relationship between the different environmental and social measures and corporate characteristics vary with both the variables chosen and the time period selected. Solomon et al (2011) find that powerful stakeholders are often not interested in the impact of the business on the global climate change, they see it as how it may impact their investee’s financial performance. They also find that investors started to identify the potential financial benefits from investment in green products and technologies. Based on these studies above, sustainability reporting does have some impact on the financial performance of the company and the decision usefulness to investors.

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The  association  between  sustainability  reporting  and  the  value  relevance  of  earnings   19   In the study of Chih et al. (2008), they investigated whether Corporate Social Reporting

(CSR) of 1653 corporations in 46 countries mitigates or increases the extent of Earnings Management during the period of 1993-2002. They find that an increase in CSR mitigates earnings smoothing and earnings losses/decreases avoidance. This is consistent with

Scholtens and Kang (2013), which suggest that firms that perform better on CSR are engaged with less earnings management. They stated that investing in CSR can reduce earnings management, but CSR is not sufficient enough to fully eliminate earnings management. Earnings management is unfavourable, because it damages the business climate, economic and social development.

Since sustainability reporting has some impact on the financial performance of the company and a positive impact on earnings management, I will expect sustainability

reporting to lead to higher earnings quality. A higher earnings quality gives an indication of better relevance of earnings in which the decision usefulness of information will increase for investors. In the study of Francis et al. (2004) they find that earnings quality has a strong conditional effect on the cost of equity capital. If the information is more relevant, users of sustainability reports can make better economic decisions about the company and the degree of usefulness can be measured by a decrease of cost of capital. However, based on prior literature we cannot clearly conclude that there is a positive or negative association between sustainability reporting and (market) returns. Thus, in this study I have developed the following hypothesis:

H1: There is an association between sustainability reporting and the value relevance of earnings.

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20   The  association  between  sustainability  reporting  and  the  value  relevance  of  earnings  

3. Research methodology

3.1 Sample selection

The initial sample will be obtained from the Datastream database for 2012. The goal is to assess the current status of the value relevance of earnings. The initial sample will be obtained from the ASSET4 ESG database that contains information about environmental, social and governance factors. The sample will consist only of European companies

(LA4RGNEU). The extraction of data from Datastream resulted in an initial sample of 979 observations from six different general industry classes1. Of these observations, 52 were removed because of missing data. Subsequently, all items with a z-score of higher than 3,29 or lower than -3,29 are considered outliers (Tabachnick and Fidell 2013). Instead of

removing the outliers, the data of the three variables RET, NI/P and change in NI/P have been truncated to the threshold of not being an outlier. There were no outliers detected in the other variables. Table 1 summarizes the sample selection process.

Table 1. Sample selection

Number of observations

Datastream sample 979

Minus observations with missing data2 52 -

Final sample 927

1

The industry classification consists of six different industries: industrial, utility, transportation, banks, insurance and other financial.

2

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The  association  between  sustainability  reporting  and  the  value  relevance  of  earnings   21  

3.2 Model specification and variables definition

To assess the relation between current firm value (measures in a firm’s stock price) and the accounting information, I use as framework Beaver’s model from the Hail (2013) paper.

Figure 2. Conceptual link between accounting numbers and firm value.

The first link assumes that the current value of the firm reflects the present value of all future cash flows and outflows (dividends). If these cash inflows and outflows are known I can compute the market price of the firm by discounting these cash inflows and outflows by the risk-free rate.

The second link describes the relation between future cash flows and future accounting earnings. For instance, in the form of an expected payout ratio, like the future payments of dividends. The pay out ratio is usually established in the dividend policy of the firm.

The third link relates the future accounting earnings with the current accounting

earnings. I can estimate the current accounting earnings by taking sources of information like management’s earnings forecasts as part of fundamental analysis. Fundamental analysis is necessary because revenues vary depending on the marketing strategy, competition in an

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22   The  association  between  sustainability  reporting  and  the  value  relevance  of  earnings   industry, sales prices etc. Also, the costs of goods sold are dependent on prices in the raw material, research and development etc.

With these three links I can estimate the current value of the firm by using accounting earnings. Reported accounting numbers contain information that is useful for investors to value the firm, what is so called the value relevance of earnings.

3.3 Earnings relation model

To measure the relation between market values and accounting numbers I use the earnings relation model from Hail (2013), because I want to examine the value relevance of earnings in the year 20123. I use the (RET) and (P) as market measures. Where (RET) represents the annual buy-and-hold stock return4 and P the market value of equity per share at fiscal year end. The accounting measures I use are (NI) and the (yearly change of NI/P). Where (NI) represents the annual earnings per share before extraordinary items, that is total NI before extraordinary items (WC01551) divided by the number of common shares outstanding (WC05301). The (NI/P) represents the annual earnings per share divided by beginning of the fiscal year stock price5 (WC05001). The change in NI/P is the year-to-year change in

earnings per share divided by the stock price at the beginning of the fiscal year. The (ε) represents the error term.

Model 1:

Earnings relation: RET = β0 +β1NI/P +β2∆NI/P + ε

3

For the most companies, the sustainability data of 2013 is not available in Datastream.

4

Stock price at the end of the year minus the stock price at beginning of the year, divided by the stock price at the beginning of the year.

5

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3.4 Value relevance of earnings and sustainability reporting

To test whether sustainability reporting has an impact on the value relevance of earnings (H1), I extend the earnings relation model of Hail (2013) by including interaction variables named (A4IR).

As interaction variable I use the A4IR data from the Datastream database, which is the “Equal Weighted Rating” that reflects a balanced view of a company’s capacity in all four areas: economic, environmental, social and corporate governance6. This A4IR variable is available for all the companies who report on sustainability. This measure is expected to be reasonably correlated with the theoretical construct sustainability reporting. As mentioned earlier in chapter 3, besides the internal and company-specific reasons for sustainability reporting, societal reasons also play an important role for reporting such as credibility and reputation. Thus, companies with more sustainable capacity are more likely to increase their sustainability reporting to enhance their credibility and reputations. The results from this model should be compared to the benchmark (model 1).

In order for H1 to not be rejected, the explanatory power of model 2 should be different than the benchmark (model 1). That is, sustainability reporting will increase or decrease the ability of earnings to predict the returns of the firm. To test this hypothesis, I will use

multiple regression analysis to statistically compare the explanatory power of model 1 and 2. I extend model 1 by including an interaction variable (A4IR):

Model 2:

Earnings relation:

RET = β0 +β1A4IR +β2NI/P +β3∆NI/P +β4A4IR*NI/P +β5A4IR*∆NI/P +ε

6

Only a small weight is assigned to corporate governance, therefore the empirical measure is reasonably correlated with sustainability reporting.

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24   The  association  between  sustainability  reporting  and  the  value  relevance  of  earnings  

4. Results

4.1 Descriptive results

Panel A of table 2 provides descriptive statistics on the market measure (RET) and the accounting measures (N/P and change in N/P). These firms have a mean value of 17.7% annual buy-and-hold stock return, with a median of 17% in 2012. The average annual earnings per share divided by the stock price at the beginning of the fiscal year is 0.0189, with an average change of -0.014 in 2012. The medians were respectively 0.07 and 0.01.

Panel B of table 2 describes the sustainability variables. These firms have an average score of 66.38 on the equal weighted rating, which reflects a balanced view of a company’s capacity in the dimensions of sustainability reporting. The median score was 77.25. The scores are equally weighted computer calculations of relative company capacity, the

benchmark being the asset4 company universe (comprises of 4000 companies). These ratings are z-scored and normalized to express the score between 0 and 100%.

Table 2. Descriptive statistics

Variables Mean Median Std. Dev. Upper Bound Lower Bound

Panel A: market and accounting measures

RET 0.1765 0.1700 0.3721 0.2005 0.1525

NI/P 0.0189 0.0700 0.2796 0.0369 0.0008

Change N/P -0.0140 0.0100 0.2458 0.0019 -0.0298

Panel B: sustainability measures

Variables Mean Median Std. Dev. Upper Bound Lower Bound

A4IR 66.3806 77.2500 28.3440 68.2076 64.5536

ENVSCORE 64.8739 76.3800 29.0897 66.7489 62.9988

SOCSCORE 66.0089 74.7600 27.8324 67.8030 64.2149

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The  association  between  sustainability  reporting  and  the  value  relevance  of  earnings   25   Table 3 shows the Pearson correlations between the main variables in model 1. As expected,

there is a significant positive correlation between the annual buy-hold-stock return and the annual earnings per share divided by the stock price at the beginning of the fiscal year and the change of earnings per share. This suggests that the information incorporated in the net income measures is also reflected in the annual buy-and-hold return. However, the equal weighted rating (moderator) is not significantly correlated with the annual buy-hold-stock return and the change in the annual earnings per share divided by the stock price.

Table 3 Correlation matrix

RET NI/P Change N/P A4IR ENVSCORE SOCSCORE ECNSCORE

RET 0.210 0.167 -0.040 -0.052 -0.039 0.015 Sig. (2tailed) 0.000 0.000 0.220 0.115 0.237 0.640 NI/P 0.704 0.076 0.006 0.026 0.204 Sig. (2tailed) 0.000 0.021 0.852 0.432 0.000 Change N/P -0.007 -0.021 -0.003 0.050 Sig. (2tailed) 0.822 0.532 0.921 0.129 A4IR 0.880 0.900 0.795 Sig. (2tailed) 0.000 0.000 0.000 ENVSCORE 0.793 0.587 Sig. (2tailed) 0.000 0.000 SOCSCORE 0.666 Sig. (2tailed) 0.000 ECNSCORE Sig. (2tailed)

The inspection of the correlations between these variables does not warrant concerns for multicollinearity between independent variables. Multicollinearity occurs when the correlations between the independent variables are so strong that they increase the standard errors of the coefficients, which in turn will make some variables statistically insignificant.

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26   The  association  between  sustainability  reporting  and  the  value  relevance  of  earnings   To address this, a multicollinearity test is performed for the independent variables in model 1. Based on the VIFs (Variance Inflation Factor) that are less than 5 and the tolerance levels that are greater than 0.20 it can be concluded that there is no concern of multicollinearity between these independent variables.

4.2 Main regression analyses

Table 4 presents the regression results for model 1 (earnings relation model). Before running the regression, the normality7 of the dependent variable was checked using the square root8 transformation to get a more normal distribution. After the calculation of the square root RET, the outliers were truncated. Based on a sample of 927 firms from the year 2012, the earnings relation model is significant and the model explains about 7.4% of the variations in returns. However, if we look at the individual effect only the net income per share divided by the market price seems to be significant. The b-value is the change in the outcome due to a unit change in the predictor, so when the net income per share divided by the market price increases by one unit, the annual buy-hold stock return will increase by 0.163 units. For this data both predictors have positive b-values indicating positive relationships. However, only the net income per share divided by market price is significantly associated with the annual buy-hold stock return in this model.

7

A distribution is normal when the skewness/std. error of dependent variable is lower than 2 (Tabachnick and Fidell 2013).

8

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The  association  between  sustainability  reporting  and  the  value  relevance  of  earnings   27   Table 5 shows the results of model 2 (earnings relation model with interaction of A4IR).

Before running the regression, the A4IR variable has been transformed with the reverse log10 transformation to reduce the negative skewness. Subsequently, I computed the centred

variables for NI/P, change in NI/P and A4IR_r_log10 to calculate the interaction variables to reduce the multicollinearity effect between the interaction variables and the original variables as suggested by Kromrey & Lynn (1998).

Table 5 model 2 regression results

B Std. Error t Sig. (Constant) 1060 0.015 70.277 0.000 N/P 0.150 0.035 4.327 0.000 Change N/P 0.050 0.039 1.263 0.207 A4IR_r_log10 0.007 0.011 0.653 0.514 NI/P_A4IR 0.044 0.075 0.596 0.551 Change NI/P_A4IR -0.178 0.085 -2.102 0.036 Observations 927.000 P-value 0.019

F-Value 16.293 Adjusted R-squared 0.076

R-squared 0.081 F Change 3.956

Table 4 model 1 regression results

B Std. Error t Sig. (Constant) 1.067 0.005 194.306 0.000 N/P 0.163 0.027 5.948 0.000 Change N/P 0.004 0.031 0.128 0.898 Observations 927.000 P-value 0.000

F-Value 36.140 Adjusted R-squared 0.071

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28   The  association  between  sustainability  reporting  and  the  value  relevance  of  earnings   The result from the regression analysis shows that model 2 has a significantly higher R-square than model 1 (F change = 3.956, p < 0.05). In other words, A4IR significantly

moderates the effect of change in NI/P on RET. The explanatory power of the variance in the dependent variable annual buy-hold-stock return in model 2 is 8.1% against 7.4% in model 1. If we look to the individual effects, only the interaction between change in NI/P and A4IR is significant, so an increase of the change in NI/P and A4IR by one unit will increase the annual buy-hold-stock return with 0.178 units.

Figure 3. Two-way interaction effects for change NI/P and A4IR variables.

Figure 3 shows the interaction effect between the variables change in NI/P and A4IR with Y-as of the annual buy-hold-stock return. The effect of low A4IR (a decreY-ase) is different than the effect of high A4IR (an increase).

1 1.5 2 2.5 3 3.5 4 4.5 5

Low Change NI/P High Change NI/P

D ep en d en t var iab le Low A4IR High A4IR

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The  association  between  sustainability  reporting  and  the  value  relevance  of  earnings   29  

4.3 Supplemental analyses

In addition, I also test for differences between the sustainability dimensions (environmental, social and economic). Whether these dimensions have different associations with the value relevance of earnings. I extend model 1 by including interaction variables ECNSCORE, SOCSCORE and ENVSCORE.

Model 3:

RET = β0 +β1ECNSCORE +β2NI/P +β3∆NI/P +β4ECNSCORE*NI/P +β5ECNSCORE*∆NI/P +ε

Model 4:

RET = β0 +β1SOCSCORE +β2NI/P +β3∆NI/P +β4SOCSCORE*NI/P +β5SOCSCORE*∆NI/P +ε

Model 5:

RET = β0 +β1ENVSCORE +β2NI/P +β3∆NI/P +β4ENVSCORE*NI/P +β5ENVSCORE*∆NI/P +ε

Before running the regressions, I also transform these variables with the use of the reverse log10 transformation. As expected, these variables are also negatively skewed, because they derived from the equal weighted rating, which was negatively skewed. After, I computed the centred variables and interact these with the accounting measures (NI/P and change in NI/P). The summarized results for the supplementary analysis for the different sustainability

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30   The  association  between  sustainability  reporting  and  the  value  relevance  of  earnings   change in N/P as independent variables, in model 2 I extended model 1 with the sustainability dimension variables (as moderators).

The results indicate that the individual environmental, social and economic dimensions are not associated with the value relevance of earnings. These results are inconsistent with Gamerschlag et al (2011) that a higher profitability of a firm is associated with more environmental disclosures. However, the economic dimension seems to have a significant effect on the value relevance of earnings. The model that includes reporting on the economic dimension explains significantly 9.2% of the variations in returns. This is higher (F change = 9.636, p < 0.001) than the benchmark of 7.4% (model 1),which suggests that there is an interaction effect.

However, the economic dimension as a moderator has only an individual effect with the change in net income per share divided by the market price. The b-value is -0.261, which implies that an increase of the change in NI/P and economic capacity by one unit will increase the return by 0.261 units. Panel D provides the interaction effect between the ECN variable and the change NI/P variable. The effect on companies with a low economic capacity is different than the effect on companies with higher economic capacities.

Finally, the association between sustainability reporting and the value relevance of earnings per industry classification has been analyzed to see whether the association is different per industry. Model 2 has been estimated in subsamples of different industries, and the R-squared face value between different industries have been compared. Appendix 3 shows the results of this analysis per industry. It appears that the association between the value relevance and the sustainability reporting is different for each industry. There is only an association between the value relevance and the sustainability reporting when an industry is classified as industrial, transportation or insurance. Especially for the last two industries the R-square is much higher.

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The  association  between  sustainability  reporting  and  the  value  relevance  of  earnings   31  

5. Conclusion

This paper examines whether the value relevance of earnings is associated with sustainability reporting. As the value relevance studies suggest that the value relevance of earnings can be influenced by several factors, and as the sustainability reporting studies suggest that

sustainability reporting is associated with lesser earnings management, it is expected that sustainability reporting has an effect on the value relevance of earnings.

To frame the current research project, Beaver’s (1998) framework has been used. It ties market values to accounting measures via future expected cash flows, dividend payout and accounting earnings. The earnings relation model (Hail 2013) has been used to test the relation between market values and the accounting measures. The explanatory power of this test serves as a proxy for the relevance of the accounting measures to predict market values. The results from this test also serve as a benchmark. Consequently, the association between the value relevance of earnings and sustainability reporting has been tested by the use of the equal weighted rating. The results of this test are compared to the benchmark. Increases in the adjusted R-square indicate a gain in the relevance of earnings; decreases suggest a loss.

Finally, the association between the value relevance of earnings and the different sustainability dimensions has been examined as well. It has also been assessed whether the association between sustainability reporting and the value relevance of earnings is different across industries.

Using a sample of 927 observations, it was found that sustainability reporting is significantly and positively associated with the value relevance of earnings. However, the effect is limited, as sustainability reporting increases the explanatory power of the earnings relation model from 7.4% to 8.1%. Only the change in earnings per share divided by market price has an individual interaction effect with sustainability reporting.

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32   The  association  between  sustainability  reporting  and  the  value  relevance  of  earnings   Additionally, this study sheds light on the possible association between different

sustainability dimensions and the value relevance of earnings. It appears that only the economic dimension has an association with the value relevance of earnings. This is

inconsistent with the result of Gamerschlag et al. (2011), who claim that higher profitability of a firm is associated with more environmental disclosures. A potential explanation for the discrepancy of the findings of the current study and the one by Gamerschlag et al. (2011) is that the current study is not only focused on Germany and environmental and social aspects, but also focused on other countries and on the economic aspect of sustainability reporting. Furthermore, there are also associations between sustainability reporting and the value relevance of earnings when the companies are categorized as industrial, transportation or insurance. This is consistent with Kolk’s finding (2005) that insurance companies have increased their sustainability reporting significantly in recent years and that the traditional polluting sectors (industry and transportation) have been most active in this regard.

The results of this study are subjected to some limitations. First, the sustainability data and the market/accounting data are drawn from European firms. This means that the findings cannot be generalized to non-European firms. Further research is needed to see whether similar conclusions can be drawn for firms operating outside of Europe. Second, the current proxy used for sustainability reporting might not be perfect, since the A4IR variable also includes a small part of the Corporate Governance score, which is not relevant for this study. As mentioned before, sustainability reporting only has three dimensions: environmental, economic and social. Further research should focus only on these three dimensions.

Also, more research should be done to analyze which industrial sector (e.g. oil or mining), transportation sector (e.g. airline or public) and insurance sector (e.g. property or health) displays a stronger association between sustainability reporting and the value relevance of earnings. This will help us improve our understanding of the relation between sustainability reporting and value relevance of earnings within these industries.

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The  association  between  sustainability  reporting  and  the  value  relevance  of  earnings   33  

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34   The  association  between  sustainability  reporting  and  the  value  relevance  of  earnings   Deegan, C. & Blomquist, C. (2006). Stakeholder influence on corporate reporting: An

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36   The  association  between  sustainability  reporting  and  the  value  relevance  of  earnings   Solomon, J.F., Solomon, A., Norton, S.D. & Joseph, N.L. (2011). Private climate change reporting: an emerging discourse of risk and opportunity? Accounting, Auditing & Accountability Journal, Vol. 24 (8). 1119-1148.

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The  association  between  sustainability  reporting  and  the  value  relevance  of  earnings   37  

Appendix 1

Variable definitions

A4IR_r_Log10 The reversed Log10 transformation for the equal weighted rating.

ECN_r_Log10 The reversed Log10 transformation for the economic dimension.

ENV_r_Log10 The reversed Log10 transformation for the environmental dimension.

SOC_r_Log10 The reversed Log10 transformation for the social dimension. ENVSCORE measures a company’s capacity to generate sustainable growth

and a high return on investment through the efficient use of all its resources. It is reflection of a company’s overall financial health and its ability to generate long-term shareholder value through its use of best management practices.

ECNSCORE measures a company’s capacity to generate trust and loyalty with its workforces, customers and society, through its use of best management practices. It is a reflection of the company’s reputation and the health of its license to operate, which are key factors in determining its ability to generate long term

shareholder value.

SOCSCORE measures a company’s impact on living and non-living natural systems. Including the air, land and water, as well as complete ecosystems. It reflects how well a company uses best

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38   The  association  between  sustainability  reporting  and  the  value  relevance  of  earnings   capitalize on environmental opportunities in order to generate long-term shareholder value.

N/P_A4IR The interaction variable of earnings per share divided by stock price and the equal weighted rating.

NI/P_ENV The interaction variable of earnings per share divided by stock price and the Environmental dimension.

NI/P_SOC The interaction variable of earnings per share divided by stock price and the Social dimension.

NI/P_ECN The interaction variable of earnings per share divided by stock price and the Economic dimension.

Change NI/P_A4IR The interaction variable of the change of earnings per share divided by stock price and the equal weighted rating. Change NI/P_ENV The interaction variable of the change of earnings per share

divided by stock price and the environmental dimension. Change NI/P_SOC The interaction variable of the change of earnings per share

divided by stock price and the social dimension.

Change NI/P_ECN The interaction variable of the change of earnings per share divided by stock price and the economic dimension.

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The  association  between  sustainability  reporting  and  the  value  relevance  of  earnings   39  

Appendix 2

Panel A: results of the supplementary analysis (environmental dimension).

B Std. Error t Sig. (Constant) 1.065 0.012 85.958 0.000 N/P 0.162 0.027 5.897 0.000 Change N/P 0.003 0.031 0.080 0.936 ENV_r_log10 0.002 0.009 0.219 0.827 NI/P_ENV 0.028 0.049 0.584 0.559 Change NI/P_ENV -0.007 0.057 -0.123 0.902 Observations 927 P-value 0.769

F-Value 14.532 Adjusted R-squared 0.068

R-squared 0.073 F Change 0.263

Panel B: results of the supplementary analysis (social dimension)

B Std. Error t Sig. (Constant) 1.049 0.015 71.306 0.000 N/P 0.159 0.028 5.764 0.000 Change N/P 0.016 0.032 0.495 0.620 SOC_r_log10 0.015 0.011 1.414 0.158 NI/P_SOC 0.072 0.054 1.331 0.184 Change NI/P_SOC -0.120 0.062 -1.931 0.054 Observations 927 P-value 0.154

F-Value 15.653 Adjusted R-squared 0.073

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40   The  association  between  sustainability  reporting  and  the  value  relevance  of  earnings   Panel C: results of the supplementary analysis (economic dimension)

B Std. Error t Sig. (Constant) 1.066 0.020 54.623 0.000 N/P 0.179 0.049 3.638 0.000 Change N/P 0.096 0.050 1.896 0.058 ECN_r_log10 0.000 0.012 0.034 0.973 NI/P_ECN -0.043 0.109 -0.393 0.694 Change NI/P_ECN -0.261 0.110 -2.373 0.018 Observations 927 P-value 0.000

F-Value 18.573 Adjusted R-squared 0.087

R-squared 0.092 F Change 9.636

Panel D: interaction effects for change NI/P and economic dimension

1 1.5 2 2.5 3 3.5 4 4.5 5

Low Change NI/P High Change NI/P

D ep en d en t var iab le Low ECN High ECN

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The  association  between  sustainability  reporting  and  the  value  relevance  of  earnings   41  

Appendix 3

: results of the supplementary analysis per industry

Industrial B Std. Error t Sig.

(Constant) 1.058 0.019 55.965 0.000 N/P 0.193 0.059 3.289 0.001 Change N/P 0.030 0.065 0.461 0.645 A4IR_r_log10 0.010 0.013 0.778 0.437 NI/P_A4IR -0.034 0.100 -0.341 0.733 Change NI/P_A4IR -0.135 0.112 -1.201 0.230 Observations 637 P-value 0.012

F-Value 14.293 Adjusted R-squared 0.094

R-squared 0.102 F Change 4.433

Utility B Std. Error t Sig.

(Constant) 0.898 0.045 20.078 0.000 N/P 0.524 0.220 2.378 0.021 Change N/P 0.038 0.226 0.170 0.866 A4IR_r_log10 0.052 0.032 1.639 0.106 NI/P_A4IR -0.340 0.356 -0.955 0.344 Change NI/P_A4IR 0.251 0.534 0.471 0.640 Observations 66 P-value 0.621

F-Value 1.878 Adjusted R-squared 0.062

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42   The  association  between  sustainability  reporting  and  the  value  relevance  of  earnings  

Transportation B Std. Error t Sig.

(Constant) 1.218 0.143 8.528 0.000 N/P -0.331 0.332 -0.996 0.330 Change N/P 0.497 0.385 1.292 0.210 A4IR_r_log10 -0.076 0.100 -0.757 0.457 NI/P_A4IR 1.506 0.757 1.989 0.059 Change NI/P_A4IR -0.563 0.836 -0.674 0.508 Observations 27 P-value 0.019

F-Value 3.650 Adjusted R-squared 0.329

R-squared 0.453 F Change 4.752

Banks/Savings & Loan B Std. Error t Sig.

(Constant) 1.107 0.072 15.473 0.000 N/P 0.075 0.067 1.114 0.269 Change N/P -0.006 0.086 -0.066 0.948 A4IR_r_log10 -0.008 0.048 -0,16 0.873 NI/P_A4IR 0.085 0.242 0.351 0.727 Change NI/P_A4IR -0.268 0.287 -0.934 0.354 Observations 76 P-value 0.585

F-Value 0.576 Adjusted R-squared -0.016

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The  association  between  sustainability  reporting  and  the  value  relevance  of  earnings   43  

Insurance B Std. Error t Sig.

(Constant) 1.062 0.059 18.104 0.000 N/P 0.923 0.233 3.958 0.000 Change N/P -0.548 0.280 -1.954 0.058 A4IR_r_log10 -0.027 0.045 -0.598 0.553 NI/P_A4IR -0.357 0.426 -0.838 0.408 Change NI/P_A4IR 1.314 0.510 2.576 0.014 Observations 41 P-value 0.012

F-Value 4.933 Adjusted R-squared 0.324

R-squared 0.407 F Change 5.040

Other Financials B Std. Error t Sig.

(Constant) 1.216 0.062 19.644 0.000 N/P 0.159 0.218 0.731 0.468 Change N/P 0.484 0.207 2.339 0.022 A4IR_r_log10 -0.098 0.036 -2.732 0.008 NI/P_A4IR 0.402 0.419 0.959 0.341 Change NI/P_A4IR -0.650 0.346 -1.878 0.065 Observations 74 P-value 0.122

F-Value 7.692 Adjusted R-squared 0.311

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Comparing the result to other studies, for example, Vannita and Shalini (2004) who found a significant and consistent upward movement for losers from month 26

Аs opposed to previous studies, the results suggest thаt there is no significаnt impаct of а modified аudit opinion over the stock returns аnd the cost of debt, becаuse the

It is of additional value to investigate the moderating effect of IR, because research has not yet found a significant positive or negative effect of integrated reporting

Panel data regression model with fixed effects are used to investigate the value relevance of the extent of GHG disclosure, integrated reporting and the moderating