What Determines Residual Income? Author(s): Qiang Cheng Reviewed work(s): Source: The Accounting Review, Vol.

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THE ACCOUNTING REVIEW

Vol.80, No. 1
2005 pp. 85-112

What

Determines

Residual

Income?

Qiang Cheng The Universityof British Columbia

ABSTRACT: This paper investigates the determinantsof residual income scaled by book value of equity,i.e., abnormalreturnon equity (ROE), by analyzingthe impact of value-creation(economic rents) and value-recording(conservativeaccounting) processes on abnormalROE. I rely on economic theories to characterizeeconomic rents and develop an empiricalmeasure-the conservative accounting factor-to capture the effect of conservative accounting. As expected, industryabnormalROEincreases with industryconcentration,industry-levelbarriersto entry,and industryconservative accounting factors. Also as expected, the difference between firm and industryabto entry,and firm normalROEincreases with marketshare, firmsize, firm-levelbarriers conservative accounting factors. Integratingthese determinantsinto the residual income valuationmodel significantlyincreases its explanatorypower for the variationin the market-to-bookratio. the residualincome valuation model; economic rents;conKeywords: equity valuation; servativeaccounting. Data Availability:The data used in this study are availablefrom sources identifiedin the text. JEL Classification: D4; G12; M4.

I. INTRODUCTION

linkframework he residual a parsimonious incomevaluation model(RIM) provides firm to estimate used It has been information firm value. to widely ing accounting valueandthe cost of equity.'The RIMmodelstatesthatfirmvalueis the sum of book value and the presentvalueof expectedfutureresidualincome.Thus,forecasting oftenrelies on Priorresearch futureresidual incomeis criticalto RIMimplementations.
1 See Lee (1999) and Lo and Lys (2000) for reviewsof RIM-based studies.
I thanktwo anonymous This paperis based on my dissertation finishedat the Universityof Wisconsin-Madison. referees, Holly Ashbaugh,Sid Balachandran, Joy Begley, Walt Blacconiere,Bob Bowen, LarryBrown, David KeatBruceHansen,Elizabeth Werner Sandra De Bondt,PeterEaston,Richard Frankel, Chamberlain, Burgstahler, ing, MarkKohlbeck,Per Olsson, StephenPenman,MortonPincus, Pervin Shroff, Shyam Sunder,Jim Wahlen, Boston College, Columbia,Cornell, JohnWild, PeterWilson,workshopparticipants at the followinguniversities: WashIowa, Michigan,Minnesota, MIT,Northwestern, Berkeley, Universityof California, GeorgiaState,Indiana, at the 2001 AAA and Yale, conferenceparticipants (St. Louis),Wisconsin-Madison, ington (Seattle),Washington AnnualMeetingin Atlanta,the 2001 SummerSymposiumon AccountingResearchat Hong Kong Universityof Science & Technology, andthe 2001 AccountingSymposium at LondonBusinessSchool,andespeciallyXia Chen, S. P. Kothari,CharlesM. C. Lee, TerryShevlin, and TerryWarfield(adviser),for valuablecommentson earlier versionsof this paper. Editor'snote: This paperwas acceptedby Patricia Dechow,Editor. Submitted January 2003 Accepted May 2004

85

86

Cheng

the linearinformation dynamicsproposedby Ohlson(1995) andFelthamandOhlson(1995) for this purpose. However,Dechow et al. (1999) and Myers (1999) find that these informationdynamicscombinedwith the RIM fail to capturefirmvalue effectively.This failure calls for a betterunderstanding of residualincome (Beaver 1999). of the determinants To this end, this paper first investigatesthe impact of value-creation(economic rents) and value-recording (conservative accounting)processeson residualincome scaled by book value of equity,i.e., abnormal returnon equity (ROE).It then examineswhetherintegrating economic and accountingdeterminants of abnormalROE into the RIM can improve its to firm value. ability explain This paperhypothesizesthat abnormalROE increaseswith economic rent proxies and conservativeaccountingfactors.It relies on theoriesof competitionto identify proxies for economic rents. These proxies measurethe extent of imperfectcompetition,under which firms can price productsabove marginalcosts and earn positive abnormalROE. Conservative accounting,such as expensing investmentswith futurebenefits,can cause recorded earningsand book value of equity to differ from economic measuresand lead to nonzero abnormalROE. To capturethe impact of conservatismon abnormalROE, I develop an empiricalmeasure,the conservativeaccountingfactor.This factor takes into consideration the impact of conservatismon both net income and book value of equity. This paper assumes that abnormalROE follows a first-orderautoregressive(AR(1)) process and allows the AR(l) parameter(i.e., persistence) to vary with economic rent proxies and conservativeaccountingfactors. Because industryabnormalROE is likely to ROE(the differencebetweenfirm have differentpersistencefrom firmdifferential abnormal at the industry and industryabnormal are conducted the ROE), empiricalanalyses separately that the level and the firmlevel. The industry-level persistenceof industry analysissuggests abnormalROE increases with industryconcentration, industry-levelbarriersto entry,and firm-level conservative The factors. analysis suggests that the persistindustry accounting ence of firm differentialabnormalROE increases with marketshare, firm size, firm-level barriersto entry,and firm conservativeaccountingfactors. level (i.e., the unconditional Like the persistenceof abnormal mean) ROE,its permanent also industries and across firms, especially over finite horizons might vary systematically analyzed in empirical studies (Mueller 1977; Zhang 2000). The abnormalROE analyses are then extended to explain the permanentlevel of abnormalROE. The results suggest that the permanent level increaseswith economic rent proxies and conservativeaccounting factors as well. ratio analyses to investigate the extent to Last, this paper conducts market-to-book which economic and accountingdeterminants of abnormalROE improveRIM implementations. Integrating these determinants into a model with currentabnormalROE and other factors examined in prior researchincreases the explanatorypower (i.e., the adjustedR2) ratio, respectively. by 40 percent and 33 percent for industry and firm market-to-book have incrementalexplanatorypower Additionalanalyses indicate that these determinants over models analyzedin prior studies (Fairfieldet al. 1996; Bhojrajand Lee 2002). This study contributesto the valuation literaturein three ways. First, it provides a of the frameworkfor forecastingfutureresidual income and improvesour understanding ROEinto link between currentand futureaccountinginformation. It decomposesabnormal an economic rent componentand a conservativeaccountingcomponent,and finds thatboth componentssignificantlyimprove forecasts of abnormalROE and the ability of the RIM

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WhatDeterminesResidualIncome?

87

to explain firm value.2Such evidence is importantfor both valuationstudies and studies that rely on the RIM valuationframework,such as value relevance studies,by suggesting a list of economic and accountingvariablesthat can capturethe cross-sectionalvariation in firm value. Second, it provides insights into the impact of economic rents on abnormalROE. Extendingpriorresearch,includingLev (1983) and Baginskiet al. (1999), this paperstudies both the persistenceof abnormal level. This paperalso uses a more ROE and its permanent set of economic This is rent comprehensive given thatdifferenteconomic important proxies. rent proxies likely correlatewith each other (Porter 1980). The analyses suggest that infirmsize, marketshare,andbarriers to entryall positivelyaffect future dustryconcentration, abnormalROE. Third,while priorresearchrecognizes the impact of conservatismon accountingnumbers (e.g., Zhang2000), thereis limitedresearchon how to empiricallycapturesuch impact. This paper develops an empiricalmeasure to capturethe impact of conservatismon abnormal ROE for individual firms. This measurereflects the notion that the conservative the accountingeffect is contingenton the growth of investmentsrecordedconservatively: effect is negative when the growthis high and positive when the growthis low. Empirical results indicate that this measurehelps forecast future abnormalROE of individualfirms and industries.Thus, this paperextends priorempiricalstudieson conservativeaccounting, such as Lev et al. (1999) and Monahan(1999), which use a portfolio approachto demonstratethe effect of capitalizingR&D expenditures meaon contemporaneous performance sures and returns-earnings other associations,among things. The remainder of the paperis organizedas follows. Section II analyzes economic and ROE and presentshypotheses.Section III describes accountingfactorsthat affect abnormal ROE analyses selection and variable measurement. Section IV reportsthe abnormal sample and Section V reportsthe market-to-book ratio analyses. Section VI concludes. II. HYPOTHESIS DEVELOPMENT that Assuming accountingsatisfiesthe clean surplusrelation(the change in book value of equity equals net income minus net dividends) and that the intrinsic value of equity equals the present value of future net dividends,one can representthe intrinsicvalue of equity (V,) by the residualincome valuationmodel (RIM):
X

+ E T=(1+ r) V,=BV

(1)

where BV, is book value of equity,E,(.) is the expectationat time t, Xa is residualincome, and r is the cost of equity, which is used to discount all futurepayoffs to equity holders. Residual income denotes the difference between net income (X,) and the requiredreturn from beginning-of-period book value of equity, i.e., Xa = Basically,the RIM Xt model states that firm value is the sum of book value and the rBV_1. present value of expected futureresidualincome.
2

Priorresearchgenerallyfocuses either on economic rents or on conservative accounting.One exceptionis a concurrent to Jansen(2002), this paper study,Jansen(2002), which also investigatesboth effects. Compared uses a more comprehensive set of economicrent proxies and allows both the persistenceand the permanent level of firmperformance to varywith economicrentsandconservative factors,insteadof attributing accounting the permanent level to conservative to economicrents,as done in Jansen effects and the persistence accounting (2002).

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88

Cheng

Accordingly, forecasting residual income is critical to implementationsof the RIM model. To improvethe forecasts,this paperinvestigatesthe determinants of residualincome. Since analysis of residual income is potentially subject to scale problems (Brown et al. residualincome scaled by book value 1999), this paperfocuses on abnormalROE (ROE"), of equity,or the differencebetween ROE and the cost of equity.In termsof abnormal ROE, the RIM model can be rewrittenas:

Vt=BVt?+EtLXROTBVtTT=l 0(1+ r)T

(1')

The RIM model holds under both unbiased accountingand conservativeaccounting. Underunbiasedaccounting,a firm'sROEequalsits cost of equity if the firmoperatesunder perfect competition.However, if the competitionis imperfect,the firm can charge prices higher than its costs; accordingly,economic rents arise and abnormalROE is no longer zero. Underconservativeaccounting,accountingmeasuresdeviatefrom economic measures. As a result,accountingROEis differentfromeconomicrateof return,anda firm'sabnormal ROE can be nonzero even if the firm operatesunderperfect competition.That is, conservative accountingis also an important determinant of abnormal ROE(Ohlson 1995;Feltham and Ohlson 1995, 1996; Zhang 2000). Below, I first decompose abnormalROE under conservativeaccountinginto a conservativeaccountingcomponentand an economic rent component,and then discuss these two componentsin detail. Economic Rents, Conservative Accounting, and Abnormal ROE Suppose that the clean surplusrelations under unbiased and conservativeaccounting are:

1+

BVy; BV;_ + X+ X,- d,, BV,= BV,_,

where d is net dividends, which are assumed to be the same under the two accounting systems, i.e., net dividends are not affected by accountingpolicies. Accounting numbers underunbiasedaccountingare denotedby " ' " the second equationfrom the first one yields: Subtracting

BV; - BV,= BV'-, - BV,_ + X; -

,.

The difference in book value of equity between unbiasedand conservativeaccountingis defined as the estimated reserve (ER), as in Penman and Zhang (2002). The estimated reserve can be interpreted as a measureof how conservativean accountingsystem is. As in Felthamand Ohlson (1996) and Gjesdal(1999), conservativeaccountingis definedsuch that the carryingvalue assigned to investmentsyields an expected accountingrateof return greaterthan the internalrate of return.Thus, the estimatedreserve is positive underconservativeaccountingand the higher the estimatedreserve, the more conservativethe accounting system. In terms of the estimatedreserve, the above equationcan be writtenas:
The Accounting Review, January 2005

WhatDeterminesResidualIncome? X - X, = ER, - ER,_1.

89 (2)

That is, the difference in net income under the two accountingsystems is the change in the estimatedreserve. Net income under conservativeaccountingis lower than that under unbiasedaccountingif the estimatedreserve increases,and vice versa. book value of equity under Dividing both sides of Equation(2) by beginning-of-period conservativeaccountingand after some algebra,one can obtain the relationbetween conservativeaccounting,economic rents, and abnormalROE:
ROEa

+ - S(1 + r)ER,_1 ER, + ROEta'

(1 +

BV~R/1
ER,

+ ROE 1 + =CAF,

B-,

(3)

See AppendixA for the derivation.This equationsuggests that abnormalROE underconservativeaccountingconsists of two components.The first component,referredto as the conservativeaccountingfactor (CAF), capturesthe impact of conservatismon abnormal ROE.The second componentcapturesthe impactof economic rents-abnormal ROEunder unbiasedaccounting. Conservative Accounting Factor and is "a prudentreactionto uncertainty to try to ensurethatuncertainty Conservatism risks inherentin business situationsare adequatelyconsidered(FASB 1980, 2)." One prime example of conservatismunder U.S. accounting is the expensing of R&D expenditures. Because the benefits from R&D expendituresare uncertain,these investmentsare not recognized as assets and are requiredto be expensed.3Expensing an investmentwith future benefits has a negative impact on abnormalROE in the investmentperiod and a positive impact for the rest of its useful life. If the growthof investmentsis high, the negativeiminvestmentson currentabnormalROE dominates the positive pact of contemporaneous impact of past investments,and if the growth is low, the positive impact dominatesthe ROEcan be captured on abnormal negativeimpact.The quantitative impactof conservatism by the conservativeaccountingfactor developed above (see Equation(3)):4
= (1 + r)ERt_1 - ER, CAFB B V,,(ERt_1 - ER,) + rER,_1

BV B V,_

Basically, CAF is the inverse change in the estimatedreserve (i.e., the net income effect) after adjustingfor the opportunitycost of the beginning-of-period estimatedreserve (i.e., the book value effect).5
3 4

An exception to this rule is that firms can capitalizeR&D expenditures associatedwith computersoftware incurred afterthe establishment of technologicalfeasibility. development ROE throughthe lagged estimated Equation(3) suggests that conservativeaccountingalso affects abnormal the lagged reserve(the secondterm).Giventhaton averageeconomicrents(ROE<') arezero due to competition, estimatedreserve is not correlatedwith abnormalROE in a cross-sectionalsetting;for simplicity,it is not consideredin the empiricalanalyses.Explicitlycontrolling for the lagged estimatedreservedoes not affectthe inferences. To see how the conservativeaccounting factor is contingent on growth, one can rewrite CAF, as (r

in investa conservative withhighgrowth forfirms ROE on abnormal accounting policyhasa negative impact ments in thoseinvestments. anda positive recorded withlow or no growth forfirms conservatively impact TheAccountingReview,January2005

- gER,)ERt_I/BV_I,, where

gER,t

(= [ER, - ER,_1]/ER,_1) stands for the growth of the estimated reserve. Thus,

90

Cheng The above discussionand Equation(3) lead to the firsthypothesis(in alternative form): H1: AbnormalROE increaseswith conservativeaccountingfactors.

Economic Rents Competitionwithin an industrycan drive prices down to marginalcosts so thatthe net presentvalue of an investmentand industryabnormalROE underunbiasedaccountingare zero. However,imperfectcompetitioncan lead to economic rents, and the less competitive an environment is, the higher economic rents are. Neo-classical economic theories suggest that the level of competitionand economic rents depend on industrystructure,i.e., industryconcentration and industrylevel barriers to entry.Concentration can yield economic rents because firms in a concentrated industry can collude and set prices above marginalcosts so that they can have positive abnormal ROE. As predicted by oligopoly theories, the effectiveness of collusion increases with concentration and Weiss 1976). Barriersto entry,on the otherhand,can induce (Strickland and sustaineconomic rents by reducingthreatsfrom outside competition.Productinnovations (temporary (buyerinertiaand loyalty), capmonopoly power), productdifferentiation ital intensity(minimumrequiredcapital),scarce resources,patents,and immobile management talents all could result in high barriersto entry (Eaton and Lipsey 1981; Mueller 1977). These discussions lead to the second hypothesis(in alternative form): H2: AbnormalROE increases with industryconcentrationand industry-levelbarriers to entry. If firms in an industry are not homogeneous as assumed in neo-classical economic to such as marketshare,firm size, or firm-levelbarriers theories, then firm characteristics, market can Firms with affect as well Martin 1983). (Brozen 1971; entry, large profitability share enjoy economic rents because large marketshare leads to economies of scale and increasedbargainingpower in an oligopoly. Similarly,large firms can enjoy economies of scale in both the productmarketand the financingmarket.Furthermore, Mueller (1986) that than firm-levelbarriersto entry are more important argues industry-levelbarriersto in entry protectingfirms from outside competition. These discussions lead to the last hypothesis(in alternative form): H3: AbnormalROE increases with marketshare, firm size, and firm-levelbarriersto entry. One can express firm abnormalROE as the sum of industryabnormalROE (ROE,,) a): (ROEj,) and firm differentialabnormalROE (DROE
ROE= ROEt + DROE ,,

wherej stands for the industryto which firm i belongs. Because industryabnormalROE varies with industrycharacteristics and firm differentialabnormalROE varies with firm these two componentsmight have differentpersistence.6 characteristics, Accordingly,this
6

This is empirically confirmed based on 219 industries and 1,052 firms with at least 25 consecutive years of data on abnormal ROE. The difference in abnormal ROE persistence (estimated from AR(1) processes) between a firm and the industry to which it belongs has a wide range. For an industry with a persistence of 0.55 (the sample average), half of the firms in the industry have a persistence higher than 0.65 or lower than 0.33.

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WhatDeterminesResidualIncome?

91

paper analyzes them separately.The industry-levelanalysis examines how industrycharacteristics affect industryabnormalROE and the firm-level analysis examines how firm characteristics affect firm differentialabnormalROE.7 III. SAMPLE SELECTION AND VARIABLE MEASUREMENT Selection Sample All firm-yearobservationsin the period 1976-1997 with availabledata on abnormal ROE and firm characteristicsfrom the 1998 Compustatdatabase are used in the abnormalROE analyses.The sample period begins with 1976, when there are enough observations to estimatethe predictedfutureindustryabnormalROE (which is used in the firm abnormalROE analyses, and the estimation of which is described in Section IV). The abnormal ROE.Regulated sampleperiodends with 1997 due to the need for one-year-ahead firms,includingfinancialinstitutions(SIC codes between 6000 and 6999) and utilities (SIC codes between4900 and4999), are excludedbecausetheiroperations aremarkedlydifferent from other firms.8Observations with book value of equity less than $1 million and those with abnormalROE greaterthan 100 percentor less than -100 percent(2.2 percentof the original sample) are droppedto reduce the influence of extreme values. The final sample consists of 3,270 observationsfor the industryabnormalROE analyses and 22,536 observations for the firm abnormalROE analyses. The sample for the market-to-book ratio analyses is describedin Section V. Variable Measurement Firm AbnormalROE Firm abnormalROE is measuredas the differencebetween ROE and the industrycost of equity, where ROE is measuredas net income before extraordinary items availablefor common equity deflatedby beginning-of-period book value of equity.The industrycost of equity is the sum of the annualizedone-monthT-billyield andthe industryequitypremium. This latter term is estimatedfrom the conditionalthree-factormodel as studied in Fama and French(1997). This paperuses the industrycost of equity because it contains smaller measurement errorsthan the firm cost of equity (Famaand French 1997). Firm Characteristics Marketshareis measuredas the ratio of a firm's sales to total industrysales. Firmsize is measuredas the natural logarithmof total assets. This paperuses threeproxiesfor barriers to entry: R&D intensity (the ratio of R&D expendituresto sales) for productinnovation, advertisingintensity (the ratio of advertisingexpendituresto sales) for productdifferentiation, and capital intensity (the ratio of depreciation, depletion,and amortization expenses to sales) for minimumrequiredcapital.However,high capitalintensitycould also resultin low abnormalROE due to high capacity adjustment costs (Lev 1983). Thus, the direction of the impact of capitalintensityis unclear. Conservativeaccountingfactors are calculatedfor R&D and advertisingexpenditures. The R&D reserve is the unamortized portionof R&D assets generatedby currentand past
R&D expenditures if these expenditures were capitalized. Similarly for the advertising reserve. R&D assets are amortized using the coefficients reported in Lev and Sougiannis
7 8

does not changethe inferencesbut makesresultpresentations cumbersome. persistence, Althoughcertainindustry characteristics are used to explainindustry performance, specialfeaturesof regulated on the rate of return,still warrant industries,such as regulations separateanalyses.See Nwaeze (2000) for a detaileddiscussionof electricutilities.

the industry andfirmanalyses whilestill allowing to havedifferent the twocomponents Combining together,

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Cheng

(1996). Advertisingassets are amortizedusing an acceleratedmethod (sum-of-yeardigits over two years), as in Penmanand Zhang (2002). Note that economic rents and conservativeaccountingeffects might be related. For example, successful R&D investmentscan affect abnormalROE throughboth economic rents and conservativeaccountingfactors. These two effects are conceptuallydistinguishable though.While abnormalROE due to economic rentsincreaseswith the level of R&D abnormal ROE due to conservativeaccountingdependson both the level and expenditures, the growth of R&D expenditures.These effects are empirically distinguishableif their empirical proxies, R&D intensity and the R&D conservativeaccounting factor, are not highly correlated.The correlationbetween these two variablesis low (-0.05) in the sample.9 Similarargumentsand correlationevidence apply to advertisingexpenditures.'0 IndustryAbnormalROE and Industry Characteristics Industriesare classified on the basis of three-digitSIC codes. IndustryabnormalROE, economic rent proxies (except concentration),and conservative accounting factors are weighted averagesof accompanyingfirm measures.The weight for an industrymeasureis the denominator used to calculatethe accompanying firmmeasure.For example,the weight for industryabnormalROE is beginning-of-period book value of equity.Industryconcentrationis proxiedby the Herfindahl Index, calculatedas the sum of squaredmarketshares of all firms in an industry-the higher the HerfindahlIndex, the more concentratedthe industry. Other Factors Prior researchsuggests that special items, accruals, and the magnitudeof abnormal ROE might negativelyaffect the persistenceof firm performance (Brooks and Buckmaster Fairfield et al. the Sloan 1976; 1996; 1996). Accordingly, empiricalanalysesinclude these referred to as other variables, factors, as control variableswhen analyzingthe incremental of economic rent proxies and conservativeaccountingfactors. These explanatorypower variablesare measuredin absolute values, and special items and total accrualsare scaled book value of equity, as done in priorresearch. by beginning-of-period Variablemeasurement is summarizedin AppendixB. Descriptive Statistics Panel A of Table 1 reportsvariablemeans and mediansat the industryand firmlevels. IndustryabnormalROE has a mean of -0.017 and firm abnormalROE has a mean of -0.053." The cost of equity is around0.14. On average, a firm enjoys 5 percent of the productmarketand has about $130 million of assets (the table reports log values.) The Herfindahl are around1.5 percent Index for an industryis around0.24. R&D expenditures
9

This low correlationreflects the underlyinglow association between the level and the growth of R&D expenditures. the results with caution.Using R&D and advertising 0oNevertheless,readersshould interpret intensityto proxy for economic rents is somewhatarbitrary and might captureconservative accountingeffects. Also, the CAF measureis sensitiveto the amortization methodand the cost of equityestimation. " The reasonfor the negativemean abnormal ROE could be that:(1) the equity premiumis overestimated; (2) firmsincludedin the Compustat Researchfile have low or negativeROE;or (3) firmswith high growth bankrupt in R&D or advertising in the sampleperiodhave negativeabnormal ROEbecauseof conservative expenditures Firmsin the last two scenariosare generallysmall and have lower weight in calculatingthe mean accounting. abnormal the meanfirm ROE(book-value-weighted ROE)thanin calculating industry averageof firmabnormal abnormal ROE (equal-weighted ROE is more negative average).This explains why the mean firm abnormal thanthe mean industryabnormal ROE.

TheAccountingReview,January2005

TABLE 1 Descriptive Statistics

ratio and estimatedreserves,are based on the Descriptivestatisticson all variables,except the market-to-book in the period 1976-1997 for firm level analyses and 3,270 industry-y observations analysis:22,536 firm-year ratio and estimatedreservesare based on industrylevel analyses.Descriptivestatisticson the market-to-book observations for i observations for firm level analyses and 3,396 industry-year ratio analysis: 19,898 firm-year B for variablemeasurement. Panel A: Descriptive Statistics on Industry and Firm Characteristics Variable AbnormalROE ROE Firm differentialabnormal Cost of equity ratio Market-to-book Marketshare Firm size Concentration Barriers to entry R&D intensity Advertisingintensity Capitalintensity Estimatedreserves (scaled by book value of equity) R&D Advertising Conservative accountingfactors R&D Advertising Otherfactors Special items Totalaccruals Magnitudeof industryor firm differentialabnormalROE Mean Industry Level Median -0.010 NA 0.140 1.848 NA NA 0.208 0.007 0.012 0.032 0.080 0.021 0.001 0.000 0.012 0.152 0.050

-0.017 NA 0.136 1.947 NA NA 0.236 0.015 0.020 0.040 0.088 0.025 0.005 0.000 0.025 0.174 0.069

h3

O E: ;S ;S Clg 3C~ ch

C ;S X

a iv o o t~

(h cs x ;s ~ZC. ;s cro TABLE 1 (continued) Panel B: Correlations between Variables C a ?r O O ~I

The upper (lower) triangle reports Spearman correlations between variables at the industry (firm) level. Abnor ROE in the upper triangle and firm differential abnormal ROE in the lower triangle. Unless noted, the correla

ROE Abnormal Marketshare Firm size Concentration

R&D intensity Advertising intensity Capital intensity Conservative accounting factor-R&D Conservative accounting factor-advertising Special items Total accruals

R&D Advertising Capital A Abnormal Market Firm ROE Share Size Concentration Intensity Intensity Intensity R -0.14 0.15 NA NA 0.03# -0.01# NA NA NA NA 0.15 NA NA NA NA 0.72 NA 0.18 -0.04 -0.07 NA -0.02# NA NA
-0.03 0.03 -0.18 0.22 0.15 -0.24 -0.09 -0.21 0.01 -0.09 0.05 0.02 0.03 -0.05 0.04 0.02 0.16 0.00# 0.00# 0.12 -0.02 NA NA NA NA NA NA NA -0.10 0.05 0.29 -0.05 -0.02 0.08 -0.05 -0.12 -0.08 0.01# 0.03 -0.03 0.36 -0.21 0.03 0.01 0.16 0.12

at the 0.05 level. is insignificant # The correlation

WhatDeterminesResidualIncome?

95

of sales for average industries and 3 percent for average firms; advertisingintensity is around2 percentand capitalintensityis around4 percent. At the firm level, unrecognizedassets from R&D and advertisingexpendituresequal 16 percentand 2 percentof book value of equity,respectively.The ratios are 9 percentand 3 percentat the industrylevel. As discussedin Section II, conservativeaccountingpolicies increase abnormalROE for firms with high growthin investmentsand decrease abnormal ROE for those with low growth;thus the averageconservativeaccountingfactoris around zero. While the magnitudeof special items is relativelysmall, about2 percentof book value of equity,the absolutevalue of total accrualsis about 18 percentof book value of equity. The absolutevalue of industryabnormalROE and firm differentialabnormalROE are on average0.07 and 0.12, respectively. Panel B of Table 1 reportsthe correlationsbetween variables,the upper trianglefor and the lower trianglefor firm characteristics. industrycharacteristics Althoughmost correlationsare significantlydifferentfrom zero, they are generallysmall and the regressions are not subjectto multicollinearity based on the conditionindex (Belsley et al. 1980).12 IV. ABNORMAL ROE ANALYSES Assuming that industryand firm differentialabnormalROE follows an AR(1) process, this section examines whetherthe AR(1) parameters vary with economic rent proxies and conservativeaccountingfactors as hypothesizedabove.13 I first reportresults when economic rent proxies and conservativeaccountingfactors are used to explain the persistence of industryabnormalROE and firm differentialabnormalROE. I then extend the analyses level of abnormalROE to vary as well. A discussion of sensiby allowing the permanent tivity tests concludes this section. The Industry Abnormal ROE Analysis This subsectioninvestigateswhetherindustryeconomic rent proxies and conservative accountingfactorshelp predictfutureabnormalROE using the following regression:
ROE~+1= + arROEa + a(xROE X Concentration, + a2ROE x Barriers to entry,

+ a3ROEt x Conservative accounting factors, + ot4ROEt x Other factors, + e +*.

(4)

The industrysubscriptis droppedfrom all variablesfor ease of notation.Industrycharacteristics are mean-adjusted within each year so that %o representsthe averagepersistence of industryabnormalROE. See Appendix B for variablemeasurement. Hypotheses 1 and 2 imply that coefficients on concentration, barriersto entry (except capital intensity),and conservativeaccountingfactors are positive.
12

13

As reportedin Panel B, firm size is highly correlated could lead to with marketshare.This high correlation coefficientson firm size and marketshareeven if theyjointly have significant insignificant explanatory power. the regression of firmsize on market shareto capture fromyearlyregressions Accordingly, analysesuse residuals the incremental is that of this approach impactof firm size beyond marketshare.The underlyingassumption marketshareis a more fundamental economicconstruct. Unlike this paper,priorresearchgenerallyassumesthe parameters to be constantacrossfirmsand over time.

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Cheng

Table 2 reports yearly regression results. t-statistics of average coefficients are used to test significance levels (Fama and MacBeth 1973). As in the regressions presented below, all independent variables are winsorized at the 1st and 99th percentiles to reduce the influence of extreme values. For comparison purposes, Column A reports results when only the current industry abnormal ROE and other factors are included. The average persistence of industry abnormal ROE is 0.79. Consistent with prior research, special items, total accruals, and the magnitude of industry abnormal ROE have negative coefficients. Column B reports the results from the full model. Although the impact of concentration is insignificant, the impact of barriers to entry is significantly positive,, as expected. Also as expected, the R&D conservative accounting factor has a significantly positive impact. The advertising conservative accounting factor has an insignificant coefficient, probably due to the short useful life of advertising investments (Kothari et al. 2002). Overall, including industry economic rent proxies and conservative accounting factors significantly increases

TABLE 2 The Industry Abnormal ROE Analysis

+ oROEI ROE',, = N, + %oROE"
+ X Concentration, + o2ROE, x Barriers to entry,

+ a3ROE Conservative accounting factors, + oa4ROEt x Other x factorst

Et+

(4)

is droppedfrom all variablesfor ease of ROE. The industrysubscript ROE' is industryabnormal The analysisis based on 3,270 industry-year notation.See AppendixB for variablemeasurement. observations in the period 1976-1997. Regressionsare estimatedyearly and industrycharacteristics are mean-adjusted within each year. Reportedcoefficientsand adjustedR2 are yearly averages. t-statisticsfor the averagecoefficientsare reported(Famaand MacBeth 1973). Wald tests are used to test whetherthe explanatory power of the model specificationin ColumnB is higherthanthat in ColumnA. The medianp-value of yearly Waldtests is reported. Column B Column A Predicted Coefficient t Coefficient t Signs -0.00 -4.88 -3.06 -0.00 ? 25.40 0.79 + 27.29 0.79 0.48 0.05 + + + ? + + -3.21 -0.31 -0.14 0.61 -2.33 -1.96 -0.78 0.62 2.75 1.17 0.69 -2.49 -3.45 -0.21 -0.07 0.64 0.0257 1.69 3.04 2.28 1.88 0.74 -2.85 -1.66 -0.29

Intercept ROEa ROEaX Concentration ROEax Barriersto entry R&D intensity Advertisingintensity Capitalintensity ROEaX Conservative accounting factors R&D Advertising ROEaX Otherfactors Special items Total accruals ROE Magnitudeof industryabnormal AdjustedR2 p-value of Waldtest
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WhatDeterminesResidualIncome?

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the explanatory power.The adjustedR2 increasesfrom 0.61 in ColumnA to 0.64 in Column B, significantat the 0.0257 level based on Wald tests.4',15 The Firm Abnormal ROE Analysis This subsectioninvestigateswhetherfirm economic rent proxies and conservativeaccountingfactorshelp predictfirm abnormalROE using the following regression:
ROE+', = + %oDROE'+ axDROE x Market sharet +I,,+ Firm size, + a3DROEa x Barriers to entry, x 2DROEa + t4DROEa x Conservative accounting factors, o+ + ROE + ctDROEa x Other factors, + e,,,. (5)

The firm subscriptis droppedfrom all variablesexcept the predicted future industryabnormal ROE (ROEj,,+), for which subscriptj representsindustryj to which the firm belongs. ROEj,a+ is used to capturethe industrycomponentof futurefirmabnormal ROE.16 Firm characteristics are mean-adjusted within each year so that %o representsthe average persistenceof firm differentialabnormalROE. See AppendixB for variablemeasurement. Hypotheses 1 and 3 suggest that coefficients on marketshare, firm size, barriersto entry (except capital intensity),and conservativeaccountingfactors are positive. Table 3 reports yearly regression results. For comparisonpurposes, Column A only includes predictedfutureindustryabnormalROE, currentfirm differentialabnormal ROE, and other factors, and Column B reportsthe results from the full model. As expected, the impact of marketshare, firm size, and barriersto entry is significantlypositive. The coefficient on the R&D conservativeaccountingfactoris significantlypositive as predicted,but thaton the advertising conservativeaccountingfactoris insignificant.Overall,incorporating firmeconomic characteristics increasesthe andconservativeaccountingfactorssignificantly A in Column to 0.34 The in Column increases from 0.30 R2 explanatorypower. adjusted at the 0.0003 level based on Wald tests. B, significant In sum, the results in this and the previous subsection suggest that as expected, economic rent proxies and conservativeaccountingfactors are positively associatedwith the persistence of abnormalROE. Allowing the persistence to vary with these determinants increases the explanatorypower by 5 percentand 13 percentfor industryand firm differential abnormalROE, respectively. Explaining the Permanent Level of Abnormal ROE While allowing the persistenceof the AR(1) process to vary,the above analysesassume its intercept,which capturesthe mean abnormalROE, to be constantacross industriesand firms. Priorresearchsuggests that this assumptionmight not hold. Mueller (1977) argues
14

15 16

This paperuses Waldtests to compare median andreports model specifications explanatory powerof alternative p-valuesof yearlyWaldtests. This relativelysmall improvement in the permanent level, partlyresultsfrom not controllingfor the variation as discussedlater. futureindustry abnormal ROEis inconsistent with forecasting Using realizedfutureindustry purposes.Predicted abnormalROE is estimatedfrom rolling AR(1) regressionsof abnormal ROE for individualindustries.For ROEof the industry abnormal ROEin 1990, all availableabnormal example,to predictan industry's up to 1989 ROEin 1989 are and abnormal (since 1963) are used to estimatean AR(1) process.The estimatedparameters then used to predictindustryabnormal ROE in 1990. To ensurethe accuracyof estimatingAR(1), at least 12 time-seriesobservations are used.

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Cheng

TABLE 3 The Firm Abnormal ROE Analysis

ROE,+1 = + aoDROE' x Market share, + a2DROE' + IROE,t+1 + %oDROEa 0o x Firm size, + o3DROEt x Barriers to entry, + a4DROEt
X Conservative accounting factors, + %aDROEt x Other factors, + E,,1

(5)

ROEa is firm abnormal ROE,

is predictedfutureindustryabnormal ROE, and ROEf,,+ DROEa is firm differential abnormal ROE. The firm subscriptis droppedfrom all variablesexcept ROEt+,, for which subscript B for See firm variable to which the Appendix belongs. j represents industry j in the period 1976-1997. measurement. The analysisis based on 22,536 firm-year observations within each year. are mean-adjusted Regressionsare estimatedyearly and firm characteristics Reportedcoefficientsand adjustedR2 are yearly averages.t-statisticsfor the averagecoefficientsare reported(Famaand MacBeth 1973). Waldtests are used to test whetherthe explanatory power of the model specification in ColumnB is higherthan that in ColumnA. The medianp-value of yearly Waldtests is reported. Column A Column B Predicted Coefficient Coefficient t t Signs -0.03 -5.40 -0.04 -5.27 ? + 18.27 0.79 0.78 18.28 + 34.77 0.61 0.62 29.44
+ + 0.17 0.01 2.00 1.98

Intercept Predictedfutureindustryabnormal ROE DROEa

DROEa x Market share DROEa x Firm size DROEa x Barriers to entry

R&D intensity Advertisingintensity Capitalintensity

+ + ? + + -

0.45 1.07 0.82 0.31 -0.38 -0.84

-0.19

2.07 2.66 2.41 2.30 -0.42 -10.94

-3.16

DROEa x Conservative accounting factors

R&D Advertising

DROEa x Other factors

Special items

-10.33
-4.07

-0.94
-0.15

Total accruals

abnormal Magnitudeof firm differential ROE AdjustedR2 p-value of Waldtest

-0.20 0.30

-2.37

-0.26 0.34 0.0003

-3.01

that because firms spend resourcesto maintainbarriersto entry and economic rents, there differencesin profitability across industriesand firms.Consistentwith might be permanent this argument,Mueller (1977) finds that firm profitabilitydoes not converge to the competitive rate of return.Mueller (1986) furtherarguesthat these differencesvary systematically with industryand firm characteristics. Similarly,Zhang (2000) models the impact of conservativeaccountingon earningsin a steady state and shows that the impact could be nonzero and varies with industryand firm characteristics as well. This subsectionextends the above analyses by allowing the mean abnormalROE, referred to as the permanentlevel, to vary with economic rent proxies and conservative

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WhatDeterminesResidualIncome?

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accountingfactors. Since the interceptof an AR(1) process is the productof the mean and 1 minus the persistence,the regressionequationfor industryabnormalROE becomes:17
ROEt+, = ROEa(1 - p) + pROEt + 4+1,

where both the permanent level (ROEa) and the persistence(p) are expressedas functions of economic rent proxies and conservativeaccountingfactors:
ROEa =

0 +f3IConcentration, + 32Barriersto entryt

+ 33Conservativeaccounting factorst + oaConcentrationt + %c2Barriers to entryt o0 + o3Conservative accounting factors, + oO40therfactors,.

p=

Coefficientsa's capturethe impact on the persistence,as in Equation(4), and coefficients level. p's capturethe impact on the permanent Table4 reportsyearly regressionresults. Since the regressionequationis nonlinearin the coefficients,the nonlinearOLS regressionmethodis used.'8The resultsfor persistence are similar to those reportedin Table 2. The impact of industryconcentration on the permanentlevel is significantlypositive, suggestingthat concentrated industriescan earnpositive abnormalROE in the long run. R&D intensity and advertisingintensity have a significantlypositive impact, as expected. Capitalintensityhas a negativeimpact (marginally level, significant).Conservative accountingfactorshave a positive impacton the permanent as expected. Overall, controlling for the impact of industry characteristicson both the level increasesthe adjustedR2 from 0.61 in ColumnA, when persistenceand the permanent current abnormal ROE and other factorsare included,to 0.67 in ColumnB, only industry at the 0.0012 level. significant The regressionequationfor firm abnormalROE is constructedsimilarly and Table 5 reportsregressionresults.The results for persistenceare similarto those reportedin Table 3. The impact of both marketshare and firm size on the permanentlevel is significantly positive. The impact of barriersto entry is mixed-marginally significantlypositive for R&D intensity,insignificantfor advertisingintensity,and significantlynegativefor capital intensity.The impact of the R&D conservativeaccountingfactor is significantlypositive, but that of the advertisingconservativeaccountingfactor is insignificant.Overall,the adjusted R2 increasesfrom 0.31 in ColumnA to 0.37 in ColumnB, significantat the 0.0001 level. the resultsin Table4 with those in Table2, or Table5 with Table3, suggests Comparing that controllingfor the cross-sectionalvariationin the permanent level furtherincreasesthe explanatorypower. Untabulatedresults suggest that the increases are significant.In sum, comparedto a model with currentabnormalROE and other factors, using economic rent proxies and conservativeaccountingfactorsto explain the variationin both the persistence
17

18

To see this, one can write an AR(1) process as: ROEt+I= 4o + pROE< + e,1. Takingexpectationsof both = 0o+ pE(ROEa). sides yields: ROEas ROEa andrearranging terms, Denotingthe mean abnormal one can obtain: E(ROE+13) is the productof the mean and 1 minusthe persistence. 40 = ROEa(1 - p); thatis, the intercept in the AR(1) processthis way yields the regression Expressingthe intercept equation. The idea of the nonlinear OLSregression is similarto thatof the OLSregression: the sumof squared minimizing errors.Basically,estimatesof the coefficientsare revisedrepeatedlyto reduce the sum of squarederrors;an can be obtained. optimalset of coefficientestimatesis foundwhen no further improvement

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100 TABLE 4 The Industry Abnormal ROE Analysis: Explaining Both the Persistence and the Permanent Level This table reportsthe resultsfrom the following regressionthat allows both the persistenceof ROE and its permanent level to vary with economic rent proxies and industryabnormal conservativeaccountingfactors:
ROE'+, = ROEa(1 - p) + pROEt + c,+1, where the permanent level (ROEF)and the persistence (p) are expressed as: ROE" =

Cheng

0 + f3,Concentration, + 32Barriersto entry,

+ 33Conservativeaccounting factors,

p = to + otConcentration, + a2Barriers to entry, + o3Conservative accounting factors, + 4,Other factors, ROE' is industry abnormal ROE. The industry subscript is dropped from all variables for ease of notation. See Appendix B for variable measurement. The analysis is based on 3,270 industry-year observations in the period 1976-1997. Regressions are estimated yearly using the nonlinear OLS regression method and industry characteristics are mean-adjusted within each year. Reported coefficients and adjusted R2 are yearly averages. t-statistics for the average coefficients are reported (Fama and MacBeth 1973). Wald tests are used to test whether the explanatory power of the model specification in Column B is higher than that in Column A. The median p-value of yearly Wald tests is reported.

Column A Predicted Coefficient t Signs

Explaining the persistence (%, ,,......c,) Intercept Concentration Barriers to entry R&D intensity Advertising intensity Capital intensity Conservative accounting factors R&D Advertising Other factors Special items Total accruals Magnitude of industry abnormal ROE Explaining the permanent level (Po, Pr1,....3) Intercept Concentration Barriers to entry R&D intensity Advertising intensity Capital intensity Conservative accounting factors R&D Advertising Adjusted R2 P-value of Wald test The Accounting Review, January 2005 + + + + ? + + ? + + + ? + + 0.61 -2.99 -0.25 -0.03 0.06 -2.03 -1.42 -0.92 1.23 0.82 27.80

Column B t Coefficient
0.82 0.02 2.12 1.92 0.78 0.94 1.60 -2.77 -0.34 -0.12 0.03 0.06 2.47 0.92 -1.48 2.61 7.27 0.67 0.0012 22.80 0.17 2.84 2.85 2.21 1.97 0.46 -5.87 -2.84 -2.54 1.99 2.25 2.06 2.55 -1.58 1.73 2.97

What Determines Residual Income?

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of abnormal ROE and its permanent level increases the adjusted R2 by 10 percent and 20 percent for industry and firm abnormal ROE analyses, respectively.

Sensitivity Tests Industry Classification

Industry classification involves a trade-off between homogeneity of firms in the same industry and appropriate classification for diversified firms. The more detailed the industry classification, the more homogenous the nondiversified firms in an industry are, but the more problematic is the classification for diversified firms. Unfortunately, there is no agreement on appropriate industry classification. Using four-digit SIC industries or the industry classification in Fama and French (1997) yields similar results.

VariableMeasurement HerfindahlIndex, to proxy for industry concentrationyields similar results. Second, the results based on alternativeestimates of the industryequity premiumare similar:(1) the
average historical equity premium for all industries (0.0516, as reported in Fama and French 1997), (2) Capital Asset Pricing Model (CAPM), and (3) the three-factor model. Using the firm cost of equity estimated from CAPM or the three-factor model also yields similar results. Third, the impact of market share and firm size could be confounded by diversification because market share and firm size might be correlated with diversification and diversification can result in a deviation of firm performance from the industry level (Mueller TABLE 5 The Firm Abnormal ROE Analysis: Explaining Both the Persistence and the Permanent Level This table reportsthe resultsfrom the following regressionthat allows both the persistenceof firm differentialabnormal ROE and its permanent level to vary with economic rent proxies and conservativeaccountingfactors:
ROEa1 = - p) + pDROEl IRO E,,+ + DROEa(1 +
E,+1,

First, using total market share of the four largest firms in an industry, instead of the

where the permanent level (DROEa) and the persistence(p) are expressedas:
share, + 32Firmsize, + DROEa = P, + P,1Market + 34Conservativeaccounting factors, p = %o+ e1Market share, + O2Firmsize, + c3Barriers to entry, + ao4Conservative accounting factors, + '5Other factors, to entry, 33Barriers

ROE~is firm abnormal ROE, and DROEa ROE,ROEat+Iis predictedfutureindustryabnormal is firm differential abnormal ROE. The firm subscript is droppedfrom all variablesexcept for which subscript j represents industry j to which the firmbelongs. See AppendixB for variable ROE7,,+1, measurement. The analysisis based on 22,536 firm-year in the period 1976-1997. observations are firm and estimated method the nonlinear OLS Regressions yearly using regression characteristics are mean-adjusted within each year.Reportedcoefficientsand adjustedR2 are yearly averages.t-statisticsfor the averagecoefficientsare reported(Famaand MacBeth 1973). Waldtests are used to test whetherthe explanatory power of the model specificationin ColumnB is higher than that in ColumnA. The medianp-value of yearly Waldtests is reported.
(continued on next page)

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102 TABLE 5 (continued)

Cheng

Predictedfutureindustryabnormal ROE (dx) Explainingthe persistence(%o, c,...cs) Intercept

Market share Firm size Barriers to entry

Column A Column B Predicted Coefficient t Signs Coefficient t + 0.77 18.87 0.76 19.37 +
+ +

0.60

30.14

0.60
0.17 0.02

24.24
2.30 2.00

R&D intensity Advertisingintensity Capitalintensity R&D Advertising

+ + ? + + -

0.15 0.14 0.17 0.58 -0.89 -0.84

-0.16

1.82 2.16 2.35 2.40 -0.79 -11.17

-3.65

Conservative accounting factors Other factors

Total accruals

Special items

-9.03
-3.73

-1.06
-0.16

ROE Magnitudeof firmdifferentialabnormal 1 level (3, Explainingthe permanent 34) o. Intercept

Market share Firm size Barriers to entry

?
+ +

-0.24 -0.11

-3.22 -5.28

-0.25 -0.11
0.48 0.02

-4.08 -4.40
4.67 3.45

R&D intensity Advertisingintensity Capitalintensity

+ + ? + + 0.31

0.32 -0.31 -0.92 0.28 0.72 0.37 0.0001

1.67 -0.96 -2.95 1.66 0.63

R&D Advertising AdjustedR2 p-valueof Waldtest

Conservative accounting factors

1977). Controllingfor diversification(measuredas the sum of squaredsales shares of all industrysegmentsin the firm) does not change the inferences. of certainvariables(capitalintensity,firm size, speFinally,because the measurement cial items, and total accruals)is affected by accountingchoices, their coefficientsmight be confoundedby conservativeaccounting effects. Using alternativemeasurementsthat are less likely to be affectedby accountingchoices-the ratioof plant,property, and equipment to sales as a proxy for capitalintensity,naturallogarithmof sales for firm size, and special items and total accrualsscaled by sales-yields similarresults. Model Estimation This paper does not analyze the impact of financialleverage on abnormalROE based on the notion that financialactivities do not create abnormalprofits and are accountedfor unbiasedly(Felthamand Ohlson 1995). Controllingfor financialleverage in the empirical analyses by adding a main effect and an interactionwith currentabnormalROE does not affect the inferences.Also, estimatingpooled regressionsyields similarresults.
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V. MARKET-TO-BOOKRATIO ANALYSES The abnormalROE analyses suggest that the determinants of abnormalROE can imabnormalROE. However,if the informationdynamic prove forecasts of one-period-ahead of abnormalROE differs from an AR(1) process, investigatingonly one-period-ahead abnormalROE is insufficientfor valuationpurposes.For instance,untabulated analyses suggest that an AR(2) process is more descriptivethan an AR(1) process for about 35 percent of the industrieswith at least 25 years of consecutivedata.Thus, this section directlylinks the determinants of abnormal ROE to firm value, i.e., the market-to-book ratio,to examine the extent to which integratingthese determinants valuation implementations. improves Like the abnormalROE analyses, the market-to-book ratio analyses are conductedat both the industryand firm levels. Marketvalue is measuredfour months after fiscal-yearends so that the capitalmarketscan integratethe information in the currentyear's financial statements.It is calculated as market value at fiscal-year-endsmultiplied by cumulated returnsin the four monthsafterwards. observations and 19,898 Overall,3,396 industry-year observations in the in and are used the the firm 1976-1997 firm-year period industry market-to-book ratio analyses, respectively.19 As reportedin Panel A of Table 1, the mean of industrymarket-to-book ratios is 1.947 and the mean of firm market-to-book ratios is 1.944. The Industry Market-to-Book Ratio Analysis The regressionspecificationfor the market-to-book ratio analyses is derivedfrom the RIM model. Scaling both sides of Equation(1') underunbiasedaccountingby book value of equity under conservativeaccounting indicates that the market-to-book ratio: (1) increases with the difference in book value of equity between unbiased and conservative accounting,i.e., the estimatedreserve, (2) decreaseswith the cost of equity, (3) increases with the growthof book value of equity,and (4) increaseswith futureabnormal ROEunder unbiased accounting,which in turn increases with currentabnormalROE and economic rent proxies.20 Thus, the regressionfor the industrymarket-to-book ratio analysis is:
MV

BV, B

of equity, + 32Growth, + f3Concentration, + to + Cost of + 34Barriers entry, aoROEa caROEa equityt + ot2ROEa x Growth, ? + 3ROEa x Concentrationt + oa4ROEa 41rBvt
l,Cost

? o+

ER

x Barriers to entry, + uotROEaX Other factors, + E.

(6)

The industrysubscriptis droppedfrom all variablesfor ease of notation.The main effects of industry characteristicsare included to capture the permanentlevel effect and their interactionswith abnormalROE are included to capturethe persistenceeffect. Growthis defined as the percentagechange in book value of equity. Other variablesare defined as before (see AppendixB for variablemeasurement.)
19 20

The market-to-book ratioanalyseshave slightlydifferentsamplesfromthe abnormal ROEanalysesbecausethe formerrequiredataon marketvalue and the latterrequiredataon futureabnormal ROE. See Cheng (2002) for a detaileddiscussionof the link from determinants of abnormal ROE to the market-tobook ratio.Theoretically, conservative abnormal accountingeffects should also be controlledfor by adjusting ROE for CAE For simplicity,the analyseshere do not make such adjustments; doing so does not affect the inferences.

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Cheng

Table 6 reportsthe yearly regression results from Equation(6) and, for comparison purposes, the results from two simpler specifications.21 Column A includes only current industryabnormalROE and other factors. ColumnB controlsfor conservativeaccounting effects by adding estimatedreserves. As expected, coefficients on estimatedreserves are significantlypositive. The adjustedR2 increases from 0.25 to 0.29, significantat the 0.01 level. This suggests that incorporatingconservativeaccountingeffects helps explain the variationin the industrymarket-to-book ratio. Column C reportsthe results from the full model. Althoughcoefficients on estimated coefficients reservesbecome insignificantaftercontrollingfor otherindustrycharacteristics, on most other industrycharacteristics are significantin the predicteddirections.The adjusted R2 increasesfrom 0.29 in Column B to 0.35 in ColumnC, significantat the 0.0036 level. Overall,these results suggest that incorporating economic and accountingcharacterratio. istics helps explain the variationin the industrymarket-to-book The Firm Market-to-Book Ratio Analysis The regressionfor the firm market-to-book ratio analysis is constructedsimilarly:
MV,
BV,

ER MV + + ,Cost of equityt f2Growth, B= + 3 2ROE BV,B ++ BVI + P3Marketshare, + P4Firm size, + PBarries to entry, + %DROE + arDROEa x Cost of equity, + o2DROEOx Growth, + c3DROE] x Market share, + c4DROE x Firm size, + X5DROE (7) x Barriers to entry, + ct6DROEax Other factors, + E,.

The firm subscriptis droppedfrom all variables except lagged industrymarket-to-book ratio (MVj,,_,/BVj,,_,) and the estimated industrypermanentabnormalROE (ROEj), for which subscript j representsindustry j to which the firm belongs. These two industryvarThe industry iables are included to capturethe industrylevel market-to-book variation.22 ROE of abnormal abnormal ROE is from estimated permanent rolling AR(1) regressions for individualindustries,as explainedin Section IV. Othervariablesare defined as before (see AppendixB for variablemeasurement.) Table 7 reportsthe yearly regressionresults from Equation(7) and from two simpler specificationsto test the incrementalexplanatorypower of conservativeaccounting and other firm characteristics separately.Column A includes lagged industrymarket-to-book the estimated ratio, industrypermanentabnormalROE, currentfirm differentialabnormal and other factors. ColumnB controls for conservativeaccountingeffects by adding ROE, estimatedreserves.As expected,coefficientson estimatedreservesare significantly positive. The adjustedR2 increasesfrom 0.33 to 0.38, significantat the 0.0001 level. ColumnC reportsthe resultsfrom the full model. As expected,coefficientson the cost of equity and on its interactionwith firm differentialabnormalROE are significantlynegative. Also as expected,coefficientson growth,marketshare,firm size, R&D intensity,and their interactions ROE are significantlypositive, except that with firmdifferentialabnormal
21

22

All observationswith an absolute value of R-studentmeasuregreaterthan 3 are identifiedas outliers and excluded(Belsley et al. 1980).Note thatthe abnormal ROEanalysesdo not identifyor excludeoutliersbecause with forecasting ROE and is inconsistent aboutfutureabnormal purposes. doing so requiresinformation with valuationpurposes. ratiois inconsistent Using contemporaneous industrymarket-to-book

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What Determines Residual Income?

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TABLE 6 The Industry Market-to-book Ratio Analysis

ER = + + ,3Cost of equity, + 32Growth,+ 33Concentration, MVt BV, BV, -ok C-, + 34Barriers to entry, + %aROEw + Cost of equity, + ot2ROEa acROEt x x Growth, + x3ROEax Concentration, + o4ROEt x Barriers to entry, + a5ROEt x Other factorst + F, (6)

MV is marketvalue, BV is book value of equity,ER is the estimatedreserve,and ROEais industry abnormal ROE. The industrysubscriptis droppedfrom all variablesfor ease of notation.See observations in The analysisis based on 3,396 industry-year AppendixB for variablemeasurement. the period 1976-1997. Regressionsare estimatedyearly and industrycharacteristics are meanadjustedwithin each year. Reportedcoefficientsand adjustedR2 are yearly averages.t-statisticsfor the averagecoefficientsare reported(Famaand MacBeth 1973). Waldtests are used to test whether the explanatory power of the model specificationin one column is higherthan that in the previous column. The medianp-valueof yearly Waldtests is reported. Predicted Column A Column B Column C Coefficient t t Coefficient t Signs Coefficient + 5.22 2.25 9.15 1.92 1.97 8.34

Intercept
Estimated reserves

R&D
Advertising
Cost of equity

+
+ +
+

0.61
2.75

2.28
3.23

-0.40
-0.27
-1.30

-0.88
-0.19
-1.99

Growth
Concentration Barriers to entry

0.01
-0.62

0.05
-0.11

R&D intensity Advertisingintensity Capitalintensity ROEa

Cost of equity Growth Concentration Barriers to entry

+ + ? +
+ +

5.35 3.75 -1.88 5.33 15.61 6.50 17.20 5.05

1.28 1.06 0.41

2.37 2.82 -2.80 13.09

0.17 2.09 1.63

ROEa x ROEa x ROEa x ROEa x

R&D intensity Advertisingintensity Capitalintensity

ROEa x Other factors

+ + ? -

24.62 11.22 -9.74 -12.04

-5.34

1.93 1.63 -1.19 -1.88

-2.46

Special items

-2.66
-4.65

-10.30
-5.12

-2.46
-4.76

-7.09
-4.26

Total accruals

Magnitudeof industry abnormal ROE AdjustedR2 p-value of Waldtest

-5.91 0.25

-3.15

-4.77 0.29 0.0092

-2.58

-7.85 0.35 0.0036

-3.65

firm size has an insignificantmain effect and marketsharehas an insignificantinteraction effect. The adjustedR2 increases furtherfrom 0.38 in Column B to 0.44 in Column C, significantat the 0.0001 level.
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Cheng

TABLE 7 The Firm Market-to-BookRatio Analysis

MV,
V = k + BVBy>1t

MV 1
+ RE7 +2ROEj

ER
+ (43 BV + "lCost

of equity, + 32Growth, Bl + share, + 34Firmsize, + P5Barriers to entry, + o-oDROEa + 33Market olDROEt x Cost of equity, + o2DROEt x Growth, + c%3DROEt x Market share,

+ o4DROEt x Firm size, + otDROE x Barriers to entry, + a6DROEt x Other factors, + e,

(7)

MV is marketvalue, BV is book value of equity, is the estimatedindustrypermanent ROEj abnormal ROE.The ROE, ER is the estimatedreserve,and DROEa is firmdifferentialabnormal firm subscriptis droppedfrom all variablesexcept and ROEj,for which subscript j MVt,,_-BVj,_, The represents j to which the firmbelongs. See industry AppendixB for variablemeasurement. in the period 1976-1997. Regressionsare observations analysisis based on 19,898 firm-year estimatedyearly and firmcharacteristics are mean-adjusted withineach year.Reportedcoefficients and adjustedR2 are yearly averages.t-statisticsfor the averagecoefficientsare reported(Famaand MacBeth 1973). Waldtest is used to test whetherthe explanatory power of the model specification in one column is higherthan that in the previouscolumn.The medianp-value of yearly Waldtests is reported. Predicted Column A t Signs Coefficient
Intercept + 1.16 7.70

Column B t Coefficient
0.97 7.44

Column C t Coefficient
1.06 7.96

Lagged industrymarketto-book ratio permanent Industry abnormal ROE

Estimated reserves

+ + + +
+ + + +

0.36 4.31

14.04 7.68

0.35 3.33 1.33 1.23

14.51 7.06 10.93 2.26

0.33 2.68 0.60 1.90

-2.74 0.15 0.55 0.02 3.77

12.85 6.11 4.60 2.95

-3.01 2.35 2.14 1.32 5.32

R&D Advertising
Cost of equity Growth Market share Firm size Barriers to entry R&D intensity

Advertisingintensity Capitalintensity
DROEa DROEa x DROEa X DROE x DROEa X DROEa x entry Cost of equity Growth Market share Firm size Barriers to

+ ?
+ + + + 5.21 16.01 5.27 15.21

0.04 0.14
5.10 -26.44 0.50 -3.03 0.40

0.06 0.20
18.67 -5.85 3.27 -0.74 4.33

R&D intensity Advertisingintensity Capitalintensity

+ + ?

3.90 7.17 -10.72

3.40 2.96 -3.25

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What Determines Residual Income?

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TABLE7 (continued) Predicted Column A Signs Coefficient t Specialitems Totalaccruals of firm Magnitude differential abnormal ROE R2 Adjusted of Wald test p-value
DROEa X Other factors

Column B Coefficient t -3.62 -0.58 -10.42

ColumnC Coefficient t -2.36 -0.84 -6.98 0.44 0.0001 -2.64 -2.14 -9.86

-1.96 0.07 -9.24 0.33

-2.71 -2.11 0.21 -0.22 -10.65 -8.09 0.38 0.0001

In sum, the market-to-book of abratio analyses suggest that integratingdeterminants normalROEcan significantlyimprovethe RIM'sexplanatory powerfor the market-to-book ratio. Additionalanalyses are conductedto investigatehow well this approachperforms relative to models used in prior studies. For example, Fairfieldet al. (1996) find that disaggregating earningscan improveforecastsof futureROE,and BhojrajandLee (2002) find that certainindustryand firm characteristics, ratio, firm includingindustrymarket-to-book profit margin, and analysts' growth forecasts, can help explain the firm market-to-book determinants ratio. The results,not reportedfor the sake of brevity,suggest thatintegrating of abnormalROE provides significantincrementalexplanatory power over models used in priorresearch,such as Fairfieldet al. (1996) in predictingfutureROE and Bhojrajand Lee ratio.23 (2002) in explainingthe firm market-to-book VI. CONCLUSIONS This paperinvestigateswhat determinesabnormal ROE.It uses industryand firmcharacteristicssuggestedby economic theoriesto captureeconomic rents and develops an empirical measure-the conservativeaccountingfactor-to capturethe impactof conservative help predictfuture accounting.The empiricalanalysesexaminewhetherthese determinants abnormalROE and help explain the market-to-book ratio. As expected, industryabnormalROE increases with industryconcentration, industrylevel barriersto entry,and industryconservativeaccountingfactors. Similarly,firm differential abnormalROE increases with market share, firm size, firm-levelbarriersto entry, and firmconservativeaccountingfactors.The market-to-book ratioanalysesfurtherindicate that integratingthese determinants of abnormalROE into the RIM significantlyincreases its explanatorypower for the variationin the market-to-book ratio. The adjustedR2 increases by 40 percentand 33 percentat the industryand firmlevels, respectively,compared with a model with currentabnormalROE and other factors suggested by prior research (i.e., special items, total accruals,andthe magnitudeof abnormal ROE).Additionalanalyses indicate that these determinants provide incrementalexplanatorypower over models analyzed in prior studies (e.g., Bhojrajand Lee 2002; Fairfieldet al. 1996). Overall,this papercontributesto the valuationliterature by investigatingdeterminants of abnormal ROEandby linkingthese determinants to firmvalue.The analysesdemonstrate the importanceof these determinants in predictingfutureabnormalROE and in explaining
23

et al. (Bhojraj The adjusted R2 afterintegrating determinants of abnormal ROEinto the model used in Fairfield at and Lee) is 0.06 (0.11) higher,a relativeincreaseof 20 percent(31 percent).Both increasesare significant the 0.001 level based on Waldtests. See Cheng (2002) for details. The Accounting Review, January 2005

108

Cheng

the market-to-book ratio. These results are importantnot only for improving valuation but also for studies relying on the RIM valuationframework,by sugimplementations, gesting a list of economic and accounting control variablesthat can capture the crosssectional variationin firm value. APPENDIX A Derivation of the Decomposition Equation (Equation (3)) Equation(2) in the paper:
X; - X, = ER, ER,_,, (2)

links the differencein net income (X) underthe two accountingsystems (unbiasedaccounting and conservativeaccounting)to the change in the estimatedreserve (ER). Accounting
numbers under unbiased accounting are denoted by " ' "

book value of equityunder Dividing both sides of Equation(2) by beginning-of-period conservativeaccountingyields:

x;
BV,_

X,
BV,_1

ER,- ER,_,
BV,_1

The first term on the left-handside of Equation(2') can be expressedas:

X
-

X;

BV;_,

BV,

BVI, BV,_,
BV,_, + ER,_1 BV;_, BV,_1

X;

= (ROEa'+ r). 1 +

t ,

ER is defined as: ER, BV' - BV,.) The second term on the left-handside of Equation (2'), by the definitionof abnormalROE, can be expressedas: X,/BVt_, = ROEa + r. Thus, the left-handside of Equation(2') can be writtenas:
B

where ROE`' (= X;/BV-_, - r) is abnormal ROE under unbiased accounting. (Recall that

X' X
gI_ l

BV ,tI_1

= (ROEa + r) =ROE RO
(

ER + BV 1 ER

-(ROE

+ r)

'(
=ROE'

I + (ERER BV 1+ BV_1 -ROEa-r ++r. B+ BVt E OEIER '1 + B r.-i + r B V,_, ROE V, BV,_I BV,_

the above equationinto Equation(2') yields: Substituting

ROEat

BV" R

+ ER'-I + r BV,
B

ROEa

ER, -ER1

ER,_

After rearranging the terms of the above equation,one can obtainEquation(3):

The AccountingReview,January2005

_BV,11

WhatDeterminesResidualIncome? ER-ER t BV~t-l +

109 ER BVt-

ROE =r*

SBV ER(1 + E
B V,1

+ ROEat .
ROEa'

(1 +

(1 + ERtB V,_

1?+ =CAF, +ROE'(

BER,
where CAF
=

(1 + r)ER - ER ( r)ERt1 -ER referred to as the conservative accounting factor.

BVI APPENDIX B Variable Measurement

Variable Panel A: Firm Abnormal ROE
Firm abnormal ROE Firm differential abnormal ROE Net income (#237),/Book value of equity (#60),_, - cost of equity, Firm abnormal ROE - industry abnormal ROE

Measurement (Compustatitem numbers in parentheses)

Panel B: Firm Market-to-BookRatio Market-to-book ratio

(Marketvalue four monthsafter fiscal-yearends),/(Book value of equity),

Panel C: Firm Characteristics-Economic Rent Proxies Marketshare Sales (#12),/[I(Sales), over the industry] Firm size Log(Assets (#6),)
Barriers to entry

R&D intensity
Advertising intensity

R&D expenditures (#46),/Sales, Depreciation,depletion,and amortization

expenses (#14),/Sales, Advertising expenditures (#45),/Sales,

Capitalintensity

Panel D: Firm Characteristics-Conservative Accounting Factors

Conservative accounting factors are calculated as: [(1 + cost of equity,)(estimated reserve),_, - (estimated reserve),]/(Book value of equity),_1. Two conservative accounting factors are calculated and the estimated reserve for each factor is calculated as follows: Estimated reserve-R&D The unamortized portion of R&D assets generated by current and past R&D expenditures if these expenditures were capitalized. R&D assets are amortized using the coefficients reported in Lev and Sougiannis (1996). To reduce data restriction, the

amortization periodis chosen to be five years are used for an industry, "otherindustries"

and the coefficients are adjusted proportionally such that they add up to 1. Coefficients for unless coefficients for the industry are reported by Lev and Sougiannis.

TheAccountingReview,January2005

110

Cheng Measurement (Compustat item numbers in parentheses)

The unamortized portion of advertising assets generated by current and past advertising expenditures if these expenditures were capitalized. As in Penman and Zhang (2002), advertising assets are amortized using an accelerated method (i.e., sum-of-year digits over two years).

Variable
Estimated reserve-Advertising

Panel E: Firm Characteristics-Other Factors

Special items Total accruals Magnitude of firm differential abnormal ROE ISpecial items (#17),l/(Book value of equity),, ITotal accruals (#18-#308),I/(Book value of a equity),_ IFirm differential abnormal ROEI

Panel F: Industry Variable Measurement

Industry measures, except the Herfindahl Index and the magnitude of industry abnormal ROE, are weighted averages of accompanying firm measures. The weight used for each measure is specified below: Industry abnormal ROE Beginning-of-period book value of equity is the weight. Market-to-book ratio Book value of equity is the weight. Barriers to entry Sales is the weight. Conservative accounting factors Beginning-of-period book value of equity is the weight. Special items and total accruals Beginning-of-period book value of equity is the weight. Herfindahl Index Sum of squared market shares in the industry. Magnitude of industry abnormal ROE Ilndustryabnormal ROEI
a

If operating cash flows (#308) is missing or unavailable (priorto 1987), it is estimatedas: funds from assets (#4) + changein current liabilities(#5) + changein cash and (#110) - changein current operations cash equivalents (#1) - changein current portionof long-termdebt (#34). Current portionof long-termdebt is set to be zero if it is reported as missing in the Compustat.

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