FIU Accounting Systematic Examination of Financial Information Paper

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The Union Institute
Graduate College
School o f Interdisciplinary Arts and Science
PROJECT DEMONSTRATING EXCELLENCE
CASH FLOW AND SECURITY VALUATION:
AN EMPIRICAL ANALYSIS OF
FINANCIAL STATEMENT ACCOUNTING EARNING
MODELS ON SECURITY RETURNS OF JAPANESE
KEIRETSU FIRMS
By
Linda Childs-Leatherbury
Ph.D. October 2001
Douglas Davidson Ph.D. Core
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UMI N um ber 3034525
Copyright 2002 by
Childs-Leatherbury, Linda C.
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ii
ABSTRACT
The Japanese equity market is the second largest in the world. In today’s global
economy, virtually all fund managers worldwide have holdings in Japanese capital
markets. Even with Japan’s premier status in global capital markets and prominence in
international financial affairs, little empirical research exists linking security returns of
Japanese firms with fundamental accounting variables. Moreover, extant research fails to
address the impact of culture on firm performance.
This research extends empirical literature on three fronts: (1) economic impact of
the keiretsu, (2) association between fundamental accounting variables and security
returns and (3) cultural influence upon accounting. Results were achieved by using data
on 100 Japanese firms listed on the Tokyo Stock Exchange. The research evaluated
whether fundamental accounting variables of firms that are part of Japanese groups
(keiretsu) significantly influence the firms’ security returns.
It is hypothesized that various financial accounting variables (i.e. cash flow, book
to market etc.) significantly influence Japanese keiretsu firms’ security returns. Results
were examined in the context of Japanese culture. The empirical results from this
analysis reject the null hypothesis that keiretsu affiliation significantly affects a firm’s
return. The study further suggests, that the degree to which accounting variables
influence security valuation varies little, based upon a firm’s affiliation with Japanese
groups.
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Acknowledgements
To those many individuals who cannot help but feel as though they have been
going to school with me, I wish to express my sincere gratitude. I wish to also thank my
committee members who were my stalwarts. I would like to thank my colleagues who
believed in me. I would be remiss if I did not thank my brothers and sisters who insisted
that I finish. I am indeed grateful to my mother, who showed me through her example,
how to persevere. To my brothers and sisters in Christ who know the power o f prayer,
and to my husband who wiped my tears and cheered me on, thanks. To my children who
climbed over my many books so they could play, and finally, to my God from whom all
wisdom and knowledge flows. THANKS!
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TABLE OF CONTENTS
List of Tables and Figures
vi
CHAPTER 1 INTRODUCTION
7
CHAPTER 2 EVOLUTION OF THE KEIRETSU
2.1
2.2
2.3
2.4
2.5
2.6
2.7
2.8
Demise of Feudalism and Creation o f Centralized Government
Establishment of an Economic System
Prewar Zaibatsu
Dismantling the Zaibatsu
Zaibatsu Give Way to Keiretsu
Cultural Composition of Keiretsu
Post War Structure of Keiretsu
Changes In The Structure Of Japanese Companies Today
13
IS
15
16
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22
CHAPTER 3 LITERATURE REVIEW
3.1
3.1.1
3.1.1.2
3.1.1.3
3.1.1.4
3.1.2
3.1.2 .1
3.1.2.2
3.1.2.3
3.1.3
3.1.4
Accounting Fundamentals and Stock Valuation
U.S. Securities and Fundamental Analysis
Security Returns
Accounting Variables
Efficient Market Hypothesis Discussion
Japanese Securities and Fundamental Analysis
Financial Reporting in Japan vs. Financial Reporting in the
United States
How the Japanese Establish Their Accounting Standards
Japan’s Approach to Earnings
Fundamental Accounting Variables and
Security Returns for Japanese Firms
Cultural Influence Upon Accounting
25
25
25
28
29
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32
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35
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CHAPTER 4
EXTANT STUDIES OF CASH FLOW INFLUENCE UPON SECURITY RETURN
VALUATIONS OF KEIRETSU FIRMS AND HYPOTHESIS FOR THE STUDY
4.1
Financial Fundamentals Impact on the Price of Japanese
Securities
45
4.1.1 Chanetal.’s Research
46
4.1.2 Charitou et al.’s Research
47
4.2
Hypothesis Developments
50
4.2.1 Hypothesis of Cash Flow and Security Valuation of Keiretsu Firms
50
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V
CHAPTER 5
THE STUDY: DATA AND SOURCES, THE SAMPLE, EMPIRICAL
MODEL AND METHODOLOGY
5.1
Variables and Descriptive Statistics
5.1.2 The Empirical Model and Methodology
52
55
CHAPTER 6
RESEARCH RESULTS AND DISCUSSION
6.1
Empirical Results of the Analysis
6.2
Empirical Results in Light of Japan Cultural
Understanding of the Keiretsu
6.2.1 Sociological and Economic Cultural Impact
6.2.2 Usage o f Financial Statements
6.2.3 Political and Economic Culture of Japan
6.2.4 Social Culture Impact Upon Business Culture
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CHAPTER 7
SUMMARY AND CONCLUSION
7.1 Limitations of the Study
7.2 Final Remarks
68
69
Reference
Appendix A List of Firms Used in this Study
Appendix B Rulers of Japan —Time Line
Appendix C Accounting Development Time Line
Appendix D Listing of Major Keiretsu Groups Group of Keiretsu
74
79
80
81
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vi
List of Tables
3.1 Number and Percentages of Companies Using
Cash Flow Statements
3.2 Cash Flow Statements Interested Parties
3.3 Traditional Cash Flow Ratios
3.4 Cash Flow From Other Financial Statements
4 Panel A: Descriptive Statistics
4 Panel B: Descriptive Statistics Correlation
5.1 Results of Test of Hypothesis- Security ReturnsModel
5.2 Results of Test of Hypothesis Pooled Correlation
5.3 Results of Test of Hypothesis Coefficients
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CHAPTER 1
INTRODUCTION
According to Dubois and Someya (1977) the developmental stages of accounting
have a pattern common to all societies, irrespective of the country, tradition, or culture.
Someya (1996) defines accounting as a human attempt to measure the results of
individual or organizational economic activities and transmit relevant information to
those interested in these activities.
It goes without saying that humans needed accounting, particularly the recording
functions which it provides, to assist the frailty of human memory.
However, the
function of accounting goes far beyond the tasks of helping humans recall important
economic transactions. Today, accounting provides individuals information concerning
the results, both good and bad, of management’s actions as they relate to economic events
and the success and or failures of such actions. Accounting does more than provide us
with historical data, it also equips us with tools to perform predictive analysis.
There has been extensive research by economists examining the relationship
among Japanese corporate groups (keiretsu). Results point to collusion as the primary
barrier to entry into the Japanese market by U.S. firms. [Fung, (1991); Lawrence (1991);
Lincoln (1990)]. Economists believe that this collusive behavior accounts for the high
prices in Japan [Prestowitz, (1988)].
Research conducted by Weinsten and Yafeh (1995); suggests that keiretsu firms
are heavily influenced by their banks to produce at levels beyond those warranted by pure
profit maximization. Lincoln et al. (1996), conclude from their examination of keiretsu
networks and corporate performance in Japan, that group firms have lower average
profitability than independents. In addition, there has been extensive research in the
accounting community, which examines the relevance o f financial reporting differences
for valuation of securities in international capital markets (Choi and Levich, 1990).
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Statement O f The Problem
There are three related issues this study will address. First, unlike in the United
States, there is less empirical data connecting fundamental accounting variables with
security returns, as they relate to firms in Japanese capital markets. Studies focusing
upon Japanese capital markets conclude that Japanese investors make less use of
accounting information than U.S. investors. [Hall, Hamao, and Harris (1994)].
Chan et al.’s (1991) research reveals that net income plus depreciation may indeed
provide greater information for investors than the price-eamings ratio for predicting
future security returns in the Japanese capital market.
The second issue relates to cultural differences. Gray’s (1988) seminal work in
culture and accounting reveals that accounting follows different patterns in different parts
o f the world.
Gray proposes four hypotheses on the relationship between identified
cultural characteristics and the development of accounting systems. Although his work
does not include empirical data, it is pertinent in that it establishes the initial prongs in
establishing the theories of cultural influence on the development of accounting systems.
In order to examine the relationship between cultures and accounting systems,
Gray hypothesized that there had to be a close correlation between culture areas and
patterns of accounting systems internationally. To formulate this hypothesis he built
upon a model introduced by Hoftstede (1980).
In Gray’s model, societal values are expressed at the level of the accounting
subculture.
He reasons, that the value systems or attitudes of accountants may be
expected to be related to and derived from societal values with special reference to workrelated values. He thereby concludes, ’accounting values’ will, in turn, impact on
accounting systems.
Gray’s work establishes a framework for analyzing the impact of culture upon the
development of accounting systems. He identifies four accounting subculture levels: 1)
professionalism, 2) uniformity, 3) conservatism, and 4) secrecy.
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Third, prior studies have examined the impact of the keiretsu upon corporate
performance and structure, while accounting researchers have studied the impact of basic
accounting variables upon security returns of Japanese firms. Yet another group of
accounting researchers have explored the impact of various cultures upon the
establishment accounting practices. None o f these researchers have examined whether or
not U.S. fundamental financial variables, which have an impact on U.S. firms, have such
an impact upon Keiretsu firms in Japan.
Research Question and Hypothesis
The lack of empirical data concerning Japanese firms begs the question as to
whether or not data obtained in research conducted in the United States will hold true for
firms in Japan. The purpose of this research is to examine, through the prism of Japanese
culture, the basic hypothesis that fundamental accounting variables of firms that are part
of Japanese groups (keiretsu) significantly influence their security returns.
Methodology
The research model developed in this study to explore the impact of security
returns upon accounting variables of Japanese firms was adopted from a model developed
by Charitou et al. (2000).
Charitou’s et al. model is detailed later in the study. In
conjunction with Charitou et al., it is hypothesized that security valuation is influenced by
accounting variables, and
that empirical results of accounting research from other
countries must be examined in light of that countries culture.
A data set for the years 1994 through 1999 on 100 firms listed on the Tokyo Stock
Exchange, along with data from firms’ annual accounting and economic reports, was used
in the study. The firms selected were limited to those that could be identified as keiretsu
firms. Keiretsu affiliation was determined in accordance with the method determined by
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Ostrom (2000). No attention was given to firm size or industrial classification.
Using multivariate analysis, empirical data is provided concerning the impact of
cash flow, earnings, cash flow from long-term debt, and book-to-market variables upon
the firms’ security value.
Social Relevance
No nation operates in a vacuum. More then ever, individual and institutional
investors are investing in the global markets.
Financial analysts rely on data from
financial accounting reports to assist in ascertaining the risks involved with various
investment options. The majority of these analytical tools were formulated here in the
United States. There is little empirical evidence that these tools translate easily when
applied to foreign financial statements.
This research provides additional empirical
evidence to support the usage of U.S. accounting measurements when analyzing foreign
firms’ financials.
An analysis of global communities must be done in the context of culture. While
the variables used to analyze American firms may be valid for American decision-makers
and investors in American firms, they may not be valid for firms whose decision makers
and investors have different value system. The evolution of values and their impact upon
systems is evident in the formation of the Keiretsu in Japan.
Interdisciplinary Aspect
To answer the question posed above, data was obtained by examining the
underlying theoretical framework in accounting as well as finance, economics and
culture.
The models, which were used to conduct the empirical analysis, were derived from the
finance discipline while the insights into the cultural implications were derived from the
discipline of sociology.
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The cultural aspect of the study is captured 1) by including the cash flow from
long-term debt in the regression model, (This is chosen, as explained further on, because
of Japan’s business cultures attitude toward debt.) 2) by using only keiretsu firms.
The remainder of this thesis is organized as follows. Chapter 2 discusses the
Japanese Keiretsu and culture. Chapter 3 contains the literature review for the empirical
research portion of the study, which focused upon cash flow ratio’s impact on a firm’s
security valuation. Chapter 4 discusses empirical work related to the study, followed by
the hypothesis investigated in the research. Chapter 5 describes the selection of data,
empirical models, research strategy, and other methodological considerations used in the
study. Chapter 6 discusses the results of the study and observed outcomes in relation to
theoretical expectations.
Chapter 7 summarizes the study, discusses expected
contributions, limitations, and conclusions.
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CHAPTER 2
Evolution of the Keiretsu
A discussion of the Keiretsu’s evolution, formation, and structure is presented
below. In addition, a probe into how Japan’s culture was interwoven in the structure of
the group is conducted. An historical understanding of how Japan’s culture influenced
the group’s formation will assist individuals in understanding the workings of the group
today.
The material for this discussion is gathered from three main sources, 1) “The
Japan Today, ” by E. O. Reischauser and Maurice B. Jansen, 2) “The Political Economy
o f Japan, “ by Kumon and Rosovsky and 3) “The Japanese Company, “ by Rodney Clark.
2.1 Demise of Feudalism and Creation of Centralized Government
Japan’s Meiji Restoration period1ushered in the industrial revolution, the demise
of feudalism, and the formation of a centralized government. Opening its boarders to the
world revealed Japan’s inability to compete with Western civilization’s global markets.
By the end of 1869, the feudal domains were replaced with prefectures administered by
individuals appointed by the central government.
The Meiji Restoration swept away the feudal system, leaving the feudal lords and
samurai looking for a way to earn a living. The central government paid the feudal lords
with government bonds. This act, according to Reischauer, not only provided financial
security to the disposed lords but was also the beginning o f the relationship between
government and business.
1 Meiji was the name of emperor who seized power from the Tokugawa. His period of
reign was 1868-1912. He is credited with modernizing Japan.
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During the seventeenth century, many family owned businesses were centered in
Kyoto and Osaka. Japan has modeled her governmental structures after those of the
West. While in the process of establishing a centralized government, she was also trying
to formulate a modem economic system.
Establishment of a modernized banking system was the first rung in the ladder.
Ownership of large family enterprises remained in the hands o f the original family, but its
management was transferred to head clerics. According to Clark, the firm was a sort of
extended family, with a strong since o f mutual loyalty between employers and employees.
Most o f the samurai2who turned businessmen during this period became
extremely successful. This, according to all three resources, was due largely to samurai’s
connections in the government. In Japan, the captains of industry came primarily from
the samurai and old merchant class, while the governmental leaders came from the old
imperial rulers.
At this point in his discussion o f the industrial period o f Japan, Reischauer issues
a caution. He advises the reader that the Meiji Restoration era should not be seen as an
inevitable developmental stage. He strongly debunks the traditional “law of history”
view where “absolutist” or trends of “bourgeois revolution” automatically followed in the
same sequence as in modem Europe. Rather, a comparison of the history of Japan from
the 1850’s to the 1880’s with that of other non-Westem countries reveal that Japan is
extraordinarily different.
Reischauer suggests that the reason for Japan’s unique development can be seen
in its internal characteristics, such as homogeneity of the people and their strong selfidentify. These cultural traits also played a critical role in the structural characteristic of
the Keiretsu.
2 The samurai were highly skilled warriors.
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2.2 Establishment of an Economic System
The creation of a nationwide monetary system, modem banking institutions, and a
national budget system established the ground work for Japan’s economic system. Japan
hired Western experts to assist in this endeavor.
At the onset of establishing an economic system, a country usually does not
typically have an abundant supply of necessary production and capital resources. The
zaibatsu group served to aid Japan in this regard, particularly in its entrepreneurial
characteristic.
A distinctive characteristic of the Japanese economy is its close relationship with
the government. Unlike in the United States, Japanese businessmen have no rivalry with
the government. Japan’s industry was established and encouraged to develop by the
government. Consequently, it has always looked to the government for patronage and
guidance. In Japan, government and businessman conduct themselves as partners rather
than opponents. One of the major economic institutions, which accounts for Japan’s
economic strength, is its business groups, which are known as the zaibatsu.
2.3 Prewar Zaibatsu
The term zaibatsu, according to all three authors, means “financial clique”. It
traditionally has been applied to financial, commercial, and industrial groups, but came to
be widely used in referring to the big businesses in Japan before World War II. Kumon
and Rosovsky believe that the zaibatsu served to fill the corporate and institutional
mechanisms needed to create a capitalistic market in Japan during its development stage.
During 1920, there were four major zaibatsu’s, 1) Mitsui, 2) Mitusubishi, 3)
Sumitomo, and 4) Yasuada. These zaibatsu controlled a huge portion of the upper level
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of the Japanese economy. This control resulted in concentration of wealth and economic
power. However, this economic wealth did not come solely as a result of their business
savvy. On the contrary, a great deal o f their success came from the control they exercised
and governmental assistance.
The Japanese government provided subsidies and material, all free of taxation.
These zaibatsu companies were also linked by common origins and common ownership,
supplied with money by the same bank, and traded preferentially with each other. These
firms benefited substantially from their privileged access to funds. Each zaibatsu had its
own bank, which supplied it with financial resources. In addition, each of the core
companies would own a further percentage of the equity of many o f the others.
Clark estimates that the zaibatsu as a group controlled 40-100 percent of the
capital o f each o f the major members. There was centralized management and co­
ordination, with the officers of the holding company holding presidencies and
directorship in the core companies. Member firms conducted business together,
particularly using group trading companies as agents and initiators o f new business. It
was not long before certain individuals began to complain about the zaibatsu.
The zaibatsu served as Japan’s entrepreneurs. According to Clark, the zaibatsu
were so powerful, that by 1941 they claimed control of thirty-two percent of the national
investment in heavy industry, and about fifty-five percent of Japan’s banking resources.
Zaibatsu group had been in existence since before the late 1880’s, yet the complaints
concerning them did not begin to surface until the 1940’s.
2.4 Dismantling the Zaibatsu
While all three authors acknowledge that the United States after the Second World
War called for the dismantling of the Zaibatsu, they are divided as to its exact reasoning
or justification. Clark believes that the United States simply considered the group as
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either a monopoly or cartel, and since such organizations hinder a free economic market,
they should be dismantled. The other authors, on the other hand, believe that it was a
political and military move. They hold that the U.S. government strongly believed that it
was the zaibatsu that enabled Japan to finance the war.
Regardless of the reason, upon the occupation of Japan, the United States called
for the dismantling of the zaibatsu. However, since the groups had been in place for quite
a while, this dismantling would take some time. During the process o f enacting such
legal institutions as the Fair Trade Commission to ensure compliance, the United States
noticed that the Japanese economy was beginning to suffer.
The United States believed that a healthy Japanese economy was in its own best
interest and as a result, suspended the aggressive posture toward dismantling the zaibatsu.
Upon leaving Japan many of the zaibatsu organizations were still in tact.
2.S Zaibatsu Give Wav to the Keiretsu
After the United States left Japan, the groups were no longer referred to as the
zaibatsu, they were instead know as the keiretsu. The Keiretsu grew out of the zaibatsu,
yet many of the zaibatsu ties, networks, and dealings still existed. What was destroyed by
the United States was the extreme exclusivity of the zaibatsu. The keiretsu took the form
of a group which chooses to deal mainly with its own members, but will, if necessary, go
outside of the group.
On this issue the authors also disagree. Some hold that the old zaibatsu were
completely dismantled and a new organization formed. Others believe that the new
organization is a by-product of the zaibatsu. Yet others believe that the keiretsu is a
group in and of itself. The evidence points to the fact that the members of the group came
out of the zaibatsu, but that the structure of the organization took a new shape.
Before discussing the current structure of the keiretsu, this is a good place to
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discuss the cultural dynamics of the zaibatsu and their similarities to the keiretsu. That
discussion will be followed by a discussion o f the current structure o f the keiretsu.
2.6 Cultural Dynamics of the Zaibatsu
Before the war, the zaibatsu operated under a central holding company. The
Zaibatsu’s holding company structure was different from that type prevalent in the United
States. In Japan, the controlling company lacked majority ownership. According to
Reischauer and Jansen, the controlling company could own as little as ten percent of the
company.
In Japan, control was executed by different means. For example, an affiliate of
the zaibatsu could be totally dependent on the banking, shipping or trading facilities of
the directors. Many firms joined the zaibatsu because of its strong sense of loyalty and
family ties. Remember, that the zaibatsu leaders came from the samurai and with them
came many of their cultural beliefs/ The samurai were warriors focused upon military
conduct and behavior such as bravery, honor, and self-discipline. A samurai would rather
kill himself than bring shame and disgrace to his family name and his lord. This was
considered an act of true honor.
After W.W.n, the Japanese army was disbanded. A new type o f warrior evolved:
one who wanted modernization and industrialization. Remember, the zaibatsu were more
like families rather than companies. Loyalty for one’s company and company name was
great. Even today, within these companies workers have great respect for their bosses and
for the heads of their companies. To be unjust or commit a misdeed would bring shame to
3 In addition to the three main sources, information about the samurai was obtained from,
Newman, John Bushido: The Way o f the Warrior.
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their company and to themselves. Today, the Japanese have a term, “Business is War.”
The combination o f the military culture and the religious teaching o f Confucianism,
Shinto, and Buddhism accounted for much of the cultural dynamics and composition of
the zaibatsu and keiretsu. Confucianism’s stress on the five moral relations between
master and servant, father and son, husband and wife, older and younger brother, and
friend and friend, are principles the samurai followed. Along with these virtues, the
samurai also held justice, benevolence, love, sincerity, honesty, and self-control in utmost
respect. Justice was one of the main factors in the code of the samurai.
Confucianism provided the Japanese with a moral basis for government, with an
emphasis on interpersonal relations, loyalty, and faith in education and hard work. This
strong sense of family loyalty, morals, self-discipline and hard work is evident in the
keiretsu group today.
2.7 Post War Structure of Keiretsu
Modem day structure of the keiretsu is as follows:4
1) Certain Industries- A variety of different types of companies are members of the
group and they go across several industrial sectors such as, food, chemical,
automobile etc.
2) Independence- Although some economists believe that the keiretsu are cartels,
each of the firms maintains separate owners as well as shareholders.
3) Banks Affiliation – There is a central bank for each keiretsu group. An example
of this is the Mitsui Bank that services approximately sixty firms.
4) Membership Secrecy – No one is absolutely sure which firms are members of the
4 Description of the characteristics of keiretsu was obtained from
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keiretsu. The Japanese are still very much a closed society. Membership is
generally determined by a cluster of characteristics.
5) Relationship – The role the group places in the firm varies from firm to firm.
Some firms need more assistance or can provide more assistance then others.
Exactly how the group functions is still a mystery. Once again, economists in the
West believe it is the group’s cartel-like structure that best describes how they
function. What is known, is that there are four fundamental mechanisms that
appear to account for the keiretsu:
1) cross-shareholding,
2) commercial transactions,
3) personnel movement, and
4) strategic coordination.
1) Cross Ownership of Shares – Each member firm owns some portion of
many o f the other firms. The core bank is likely to own up to five percent
of each member firm. However, the controlling shares of the firms are
held within the family and are maintained on a long-term basis. The group
is not concerned with the current market price of the member firms’ stock
because the majority5of the shares are held by the members.
21 Commercial Transactions – When member firms need capital, they term
to the core bank. When conducting business transactions they turn to
member firms. Companies obtain their supplies, inventory, and equipment
from member firms. This behavior is in contrast to how business is
conducted in the U.S. Member firms do not necessarily seek the lowest
5 This fact is important to remember when examining the empirical data in later
chapters.
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price, or bid for contracts. On the contrary, they first look to member
firms to supply resources regardless o f the price.
3) Personnel – It is common for bank officials to be board members of the
group firms. It is also common for senior personnel from one group firm to
be hired by another group firm. Member firms also do a great deal of
networking, especially among technical personnel.
41 Strategic Coordination – The chief executive officers of the member
firms meet to strategize. They discuss ways o f keeping firms solvent and
profitable. All other firms in the group can subsidize a company in an
important strategic position.
Banks play a unique and pivotal role in the workings of the keiretsu. Below is a
discussion of their role.
•
Bank Support – if a member firm falls upon financial difficulty, and is unable to
honor its interest and principle payment obligation, the bank will typically permit
deferment of repayment while approving new additional loans. It is unusual for a
bank to foreclose on a member firm. In such situations, the bank officials, along with
member firms’ chief financial officers, organize a merger between ailing firms and
strong firms. Usually, the banks will make good on any outstanding debts to third
parties. Most non-member firms rely on foreign financial assistance.
•
Bank Control – What the banks require in exchange for the long-term security and
support is power and influence with the keiretsu group. It is not uncommon for bank
presidents to serve on the board of directors of the member firms. In this manner, the
banks execute management decisions within the firms.
•
Credit/Shareholder and Debt/Equitv – Firms in Japan view debt/equity differently
than it is viewed in the U.S. It is essential to understand this difference when
comparing Japanese firms’ balance sheets to U.S. firms’ balance sheets. It may
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21
appear to outsiders that Japanese firms have very little equity and a large amount o f
debt.6 That is because we would be applying U.S. accounting standards and policies.
Rather than looking at debt to equity, for Japanese firms it would be more prudent to
look at equity to debt. It addition, the bank should be viewed as the shareholder and
not the creditor.
•
Shareholders as Creditors – Shareholders of member firms are in a low risk
position. Shareholders who are outside of the group supply only a small fraction o f
the total financing of the member firms. Dividends rarely fluctuate with earnings. In
contrast, they are typically a fixed percentage of the par issuing value of the stock.
2.8 Changes In The Structure Of Japanese Companies Today
Today, the central role of the commercial bank is changing in terms of power and
influence. Dependence on the bank is diminishing because many companies now have
greater cash resources and credit ratings. Capital markets and equity markets are
developing, and large companies are able to issue their own securities. Securities
companies may take the place of the banks at the center of industrial groups. Whether the
bank or the securities company sits at the center of Japanese keiretsu, the power of these
groups is likely to remain for the long term, and to have profound consequences for
foreign investors, business, and competitors.
6 It is not unusual for a firm to have 70% to 90% of borrowed capital in short term
bank loans. This would be unheard of in the U.S.
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22
Chapter 3
Literature Review
The theoretical underpinning for this research is gathered from several sources. It
is an investigation of the potency of fundamental accounting variables in forecasting the
security returns of keiretsu firms in the context of Japan’s social, economical, and
political culture.
From the perspective of financial accounting, accounting information is
informative vis-a-vis its predictive ability with respect to future eamings/dividends. This
is the predictive value,7 which is one of the major arguments for the relevance of
accounting information. Much of the empirical research is built upon models borrowed
from the discipline of finance. It focuses mainly on the theories introduced through
capital market research. The proposition, which specifically relates to this body of study
is the efficient-markets hypothesis. Under this theory, market prices are assumed to fully
reflect all publicly available information. In addition, return on a security is a function of
risk: volatility of the security’s return relative to the volatility of the entire security
market.
This efficient-market hypothesis has a certain degree of significance for
accounting. Because of the efficient-market hypothesis stated above, many accountants in
the United States have investigated the relationship between accounting-based measures
of risk. Accounting based measures of risk typically include financial statement ratios.
This paper adds to that body of knowledge by exploring the significance of those
measures when applied to Japanese firms.
Chapter 3 discusses the theoretical framework for this research, based on models
detailing the ability of fundamental variables to aid in the analysis of the security
valuation of firms in international capital markets, as well as the role o f culture in
7 Statement of Financial Accounting Concepts (SFAC) No.2, p. 15
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23
formulating international accounting environments. The scope of this research is further
narrowed by limiting its analysis to the capital markets o f Japan and its keiretsu firms.
3.1 Accounting Fundamentals and Stock Valuation
Theoretically, one can determine the value of a firm by closely examining the
firm’s financial statements. A fundamental question arises as to what procedures are used
in ascertaining such an assessment. Traditional methods of achieving this information are
through the use of financial statement ratios. Financial analysts use these ratios in their
determination of a firm’s value.
3.1.1 U.S. Securities and fundamental Analysis
One could say that financial statement analysis pinpoints various components of
financial statements that are relevant to investment decisions. In the United States, there
has been a plethora of research, which attempts to uncover the value-relevance of
accounting attributes in hopes of enhancing financial statement analysis.
As mentioned previously, one of the primary qualities of accounting information
is its predictive value.
The Financial Accounting Standards Board (FASB) has
determined that the primary users of financial information who are interested in its
predictive value are investors and creditors. These individuals are concerned mainly with
the amounts, timing, and uncertainties of future cash flows.8
3.1.1.2 Security Returns
8 Statement of Financial Accounting Concepts (SFAC) No. 1, para. 24-30.
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24
The relationship between accounting data and security value began with the
seminal work of Beaver (1968).
Lev and Ohlson (1982) also stress the pertinence of
including stock valuation when conducting accounting research. Atiase and Tse (1986)
perform an exhaustive review of various stock valuation models and accounting
information.
A valuation approach consists of an examination o f the relationship
between levels of stock prices and fundamental variables, primarily accounting data.
Since an investment is a commitment of funds for a period of time to derive a rate
of return that would compensate the investor for the time during which the funds are
invested, then, the initial step in making such an investment is ascertaining your required
rate of return. The majority o f investments have expected cash flows and a stated market
price. Therefore, you must examine the investment to ascertain if its market price is
representative of your expected rate of return. Provided your investment is in corporate
securities, you must first estimate the value of the security based on its expected cash
flows in relation to your required rate of return.
Valuing common stock can be accomplished by applying various techniques.
Generally, all the techniques fall within two major classification: (1) the discounted cash­
flow valuation techniques, where the value of the stock is estimated based upon the
present value of some measure o f cash flow, including dividends, operating cash flow,
and free cash flow; and (2) the relative valuation technique, where the value of a stock is
estimated based upon its current price relative to variables considered to be important,
such as earnings, cash flow, book value etc.
The model used in this study follows the
second technique.
It was Beaver’s (1981) usage of the dividend valuation model that helped
establish the role of accounting earnings in ascertaining a firm’s value. This approach
stresses the importance of dividends as one of the most important variables in
ascertaining a firm’s value. The dividend model assumes that the value of a share of
common stock is the present value of all future dividends. Although the model was
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25
initially introduced by Williams (1938), Gordon (1962) expanded and popularized the
model.
The dividend valuation model was introduced by Gordon and is a valid starting
point in comprehending the relationship between accounting data and the value of the
firm. His model posits that the value of the firm to stockholders is the present value of
future expected dividends to be received by stockholders.
Vj = D‘ +
(1+k)1
P7
ii 1 ?
(1+k)2 = Z (1+k)1
t=l
Standard dividend discount model
Po =
(l-b)Yo
k-rb
Gordon’s expanded model
Where
R= company’s rate of return of assets
Yo= current net income
K = rate o f decline of the value of the dividends
B= constant earnings retention rate
Po= current security price
As mentioned previously, accounting’s posit is that accounting income is useful in
predicting future earnings (such as dividends)9. Therefore, accounting information has
9
This is so because dividends are directly a result o f a firm’s accounting
income/eamings.
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26
value indirectly through its role in assessing future expected dividends.
3.1.1.3 Accounting Variables
Miller and Modigliani (1958, 1965) established that certain accounting variables
have informative value. One is tax, which could be isolated and treated as a separate
variable. Another variable of particular importance to this study is cash flow variables.
Their influential study argues that dividend policy is irrelevant to firm valuation. Their
study that eliminated the effects of taxes, showed that the value of the firm could be
equivalently modeled (while ignoring dividends) as the present value o f future net cash
flows, in which they define cash flow as cash flow from operations minus cash
investments in assets.10
The beauty of the cash flow valuation model for accounting is how it adequately
leads directly into the accounting systems. The most important to this study is cash flow
because cash flows are explicitly measured in accounting.
It is clearly spelled out in SFAC No. 1 that the role of financial reporting is aiding
investors, creditors, and others in assessing the amounts, timing, and uncertainty of the
enterprise’s future net cash inflow. In fact, there are various empirical studies, which
argue that future cash flows are a better predictor of a firm’s value than accruals.”
It can be clearly seen that the true value of accounting information is not in its
historical presentation but rather its usefulness in providing insight into future
10 Readers should not find it surprising that this is the same definition used in capital
budgeting present value calculations.
11 Bowen, Burgstahler, and Daley (1986) and Greenberg, Johnson, and Ramesh (1986)
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27
occurrences. This information, however, is not only beneficial to creditors but to investors
as well.
3.1.1.4 Efficient Market Hypothesis discussion
Efficient market hypothesis (EMH) led researchers to conclude that accounting
information matters to security value predictors. Incorporated in this posit is the test of
the EMH.
When referring to the EMH, financial analysts are explaining how quickly
securities in the capital markets respond to announcements of new information. It is held
that in an EHM, a) markets completely reflect available information and b) market prices
respond to such information.12 That is to say, whenever new information is introduced to
the market place, security prices react.
If the EHM theory is true, then one could
conclude that certain accounting information only has value to investors if there is
evidence that prices vary with new information.
Clearly, there is some degree of
efficiency present in securities-market transactions. However, if EHM is incorrect, does
that make accounting information irrelevant to investors and creditors?
Ou and Penman (1989) researched the idea o f fundamental analysis. This concept
assumes that security markets are inefficient and that under priced shares can be found by
means of financial statement analysis. That is to say, financial statement ratios and
measures provide information that may not have been reflected in the price o f the security
and therefore the security is undervalued.
The Ou and Penman view is directly opposite to that held by those who adhere to
the EHM theory. In their research, Ou and Penman applied fundamental accounting
measurements such as; return on assets, gross margin, and percentage of change in
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28
current assets. They used a multivariate model to predict whether a firm’s income would
increase or decrease in a subsequent year. Their research covered the period between
1956 and 1977. They were able to determine the following year’s earnings changes
correctly, almost 80 percent o f the time. What they were trying to prove, was that the
market overlooked information pertinent to the earnings capacity o f the firm and that the
information could be obtained from a fundamental analysis o f accounting measurements.
Once again, this researched raised questions concerning the correctness of EHM
Lev (1989) conducted research which complements the work performed by Ou
and Penman. Lev’s view was that there are time elements involved in market efficiency.
That is, that over time and within years, the correlation between earnings numbers and
stock returns proved extremely low. Lev’s cross-sectional study stated that earnings have
very little explanatory power relative to changes in stock prices.13
The research conducted by Ou and Penman, and Lev complement each other
because Ou and Penman conclude that there is a predictive role for accounting data in the
market and Lev finds a low explanatory relationship between earnings and stock returns.
While various researchers have concluded that cash flow information is pertinent
in predicting security valuation, a number of researchers are uncertain as to if it is a better
predictor than earnings calculated using traditional accrual methods o f accounting.
Dechow14 investigated both accruals and cash flows as measures of a firm’s
performance. Her research extended that conducted by Bowen, Burgstahler, and Daley,
(1987). Bowen, Burghstahler, and Daley’s research focused upon ascertaining whether
13 That means that the statistical value R2 which measure the coefficient of correlation
would be less than 1.
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the unexpected component of earnings or cash flows can significantly explain abnormal
stock market returns. Findings from that research revealed that both earnings and cash
flow can incrementally provide information.
Dechow’s research questioned if one variable was superior to the other. That is,
she wanted to know if earnings or cash flow provided a greater indicator of a firm’s
security valuation. She concluded that various timing issues greatly affected whether
earnings or cash flow was a superior indicator.
It is evident from the U.S. researchers that fundamental accounting analysis
provides significant decision making data to U.S. investors and creditors, concerning a
firm’s security valuation. Most individuals are aware that the scope of investing has
become global in nature. Many U.S. individuals, as well as institutional investors and
creditors, are involved in not only domestic but also international capital markets.
3.1.2 Japanese Securities and fundamental Analysis
International trade and investment during the last quarter century have increased
dramatically. If one looks at imports, it can be seen that they have increased from $15
billion in 1960 to $804.5 billion dollars in 1995.,s The global capital markets and the
overwhelming U.S. empirical research which links fundamental financial analysis with
security returns begs the question, do empirical research results hold if applied to foreign
firms?
This research provides further data that will assist in answering that question and
add to the body o f research. Although some researchers have provided some insight into
how U.S. fundamental analysis is applied to foreign firms, more research is needed.
15 Statistical Abstract of the United States(1995), p. 815
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Various issues impact such research. One of the pertinent issues is the difference
between financial accounting and reporting in various countries. One obstacle to
accounting research is the translation of foreign operations, another is that of national
accounting differences and finally the role of culture in accounting development.
A thorough discussion of each of these is beyond the scope of this research.
Therefore, the following discussion is limited to the one country, which is the focus of
this study, Japan. Below is an overview of the differences between Japanese and U.S.
accounting. A fundamental understanding of the differences between the two accounting
systems is critical to understanding as well as drawing conclusions from empirical data
using U.S. models applied to Japanese firms.
3.1.2 .1 Financial Reporting In Japan vs. Financial Reporting in the United States
The primary reason for choosing Japan is that it is the second largest economic
power in the world. In the midst of extreme oligopolistic economic dominance, the
Japanese accounting profession was established. In Japan, the government dominates
accounting standards.
Initial accounting regulations were implemented in the late
Nineteenth Century and modeled after those used by France and Germany (Someya,
1996)
In Japan, the tax laws have the greatest impact upon accounting standards and
procedures. Unlike here in the United States, Japanese accounting procedures are mainly
concerned with providing protection for the creditor rather than providing information for
the investors (Someya, 1996).
The Commercial Code of Japan was enacted in 1899 and last revised in 1974.
The Commercial Code requires that directors of a corporation shall prepare and submit
for approval to the general meeting of stockholders the following documents:
1. Balance sheet
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31
2. Income statement
3. Summary of operations
4. Proposals concerning the apportionment of net income.
Corporations are obligated to make available their financial statements and their
schedules as well as their auditor’s report at their head office for inspection by
stockholders and creditors. The main problem with this structure is that only the balance
sheet must be released to the public if it is a closed company. Furthermore, companies
are not required to disclose their income statement, which shows their short-term
performance.16
Balance sheet information is more closely associated with long-term performance
than short-term performance. This is important because in Japan, most firms are small
and family owned. The large firms in Japan are mostly owned by large banks. Because
banks represent the shareholders in most firms, it is relatively easy for them to acquire
financial data on the firm. In addition, many bank personnel also are on the board of
directors of the firms they own. Therefore, to ascertain the financial condition of a firm
the stockholders can rely on an intricate network of relationships already established
through the existing structure. This means the formalized financial statement is not
needed to obtain financial information concerning a firm. The primary reason they are
not needed is because of the high level of trust that exists between the shareholder and
company. The banks (which are the owners) trust the corporate officials, who in most
cases were appointed by the bank.
This intricate networking (know as the keiretsu) reduces the need for external
financial reports and their relevancy to the decision making process. This close-knit
16 Although the Ministry of Finance in Japan in May of 2000 implemented Banking
reform regulation which calls for full disclosure policies many firms have yet to comply.
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32
relationship further explains Japan’s apparent unwillingness to adopt full disclosure
regulations sought by global market participants.
3.1.2.2 How the Japanese establish their Accounting Standards
In Japan, generally accepted accounting principles (GAAP) are adopted into law.
GAAP as law in Japan tends to carry more weight because of the legal connotation. In
Japan, accounting standards can be introduced for greater political reasons then
professional reasons. That is not to say that some of the accounting standards in the
United States do not have political influence, but rather that it tends to have greater
relevance in Japan.
The fact that accounting standards are established by law in Japan
makes changing Japanese standards an extremely slow and bureaucratic process. This is
in contrast to U.S. GAAP, which is established, and self regulated by the profession.
Japan’s Business Accounting Deliberation Council (BADC) is an advisory board
for the Ministry of Finance. It is the Ministry of Finance, which passes bills concerning
accounting procedures and standards. Japan’s Commercial Code, which is implemented
by the Ministry of Justice, applies to corporations in general (Someya, 1996).
3.1.23 Japan’s approach to earnings
Since the Japanese are primarily conservative in their accounting methods17
considerable attention is placed on the following:
1) historical cost
17 Which in accounting terms means that it is better to understate a firm’s value than to
overstate it.
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33
2) accelerated depreciation methods and shorter asset lives
3) goodwill is not capitalized
These items receive far less attention in the United States
There is far less (if
any) demand upon Japanese firms to consistently produce short-run profits. It is widely
held that managers of Japanese firms are rewarded for producing long-term profits.
Everyone knows that here in the United States, quarterly earnings reports are essential.
Furthermore, debt financing through the Japanese banking system is far more important
than equity financing in contrast to that in the United States18
3.1.3 Fundamental Accounting Variables and Security Returns for Japanese Firms.
Blaine (1993), and Constand et al. (1991) focused their research upon the price
earnings ratios and factors that influence market values of Japanese firms. Their research
focused upon comparing the results of U.S. financial analyses with that from Japanese
firms. What the aforementioned researchers failed to do, and what this paper attempts to
do, is examine various fundamental financial analysis impacts upon a firm’s security
valuation in the context of a country’s (Japan’s in this case) culture. In particular, a
variable is added that addresses long-term performance. The type of firms selected are
limited to keiretsu.
3.1.4 Cultural Influence Upon Accounting
Choi et al. (1983) conducted the seminal research in this area. They state
18 The Japanese economy has seen a change in this approach as it struggles to overcome
the current recession. The major collapse o f very large banks have caused firms to
consider greater levels of equity financing then they have ever done.
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34
“Financial ratios, which may be appropriate measures of financial risk and return, are often
misused19 when applied to foreign companies.” He goes on to state “ …They are misinterpreted because
the U. S. investor does not understand a particular foreign environment that influences all financial ratios in
that environment”
The researchers conclude that in evaluating a foreign firm, the analysts should
also examine whether or not the firm is a member of a industrial group and/or banksupported. A major conclusion of their study is that meaning and significance (from
financial analysis of foreign firms) come from and depend upon an understanding of the
environmental context from which such numbers are drawn.
The majority o f all cross-cultural accounting research has been obtained from
work conducted by the Dutch engineer and social scientist G. Hofstede. Hofstede (1980)
performed an extensive survey of 80,000 IBM employees in 66 countries across seven
occupations. He concluded that there were four dimensions of national culture. It is
beyond the scope of this research to examine Hofstede’s findings in depth. Rather, it is
introduced here to highlight the pertinence of reinforcing the conclusion of Choi et al. that
whatever research data is gathered must be analyzed in light of the cultural context and
environment from which it is drawn. For the purposes of this paper, the focus is on the
cultural context of the Keiretsu.20
Based on the Hofstede model, the Japanese seem to be especially intolerant of
uncertainty and fall within his description of collectivist, while Americans would fall
within his category of individualism. Japan’s intolerance of uncertainty may explain the
statutory nature of the accounting standard-setting process and the limited role of its
accounting profession. Bloom et al. believe that the Japanese place more emphasis upon
forecasts in their financial reports than is the case in the United States and that this further
19
Italics added
20 Keiretsu formerly referred to as the zaibatsu, is a special group of firms with Japan
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35
illustrates their intolerance of uncertainty.
According to Hofstede, accounting is a ritual for dealing with uncertainty.
Forecasting can likewise be seen as an attempt to deal with an uncertain future. Bloom et
al. reiterate Choi et al., warning that one cannot evaluate Japanese accounting figures in a
vacuum.
They stress that the historical legacy, economic environment, and cultural
norms of the country must all be considered.
Additional empirical evidence to clarify the question, of to what degree Japanese
investors utilized which financial statement data, can be gained by regressing various
cash flow ratios. It is hypothesized that cash flow ratios play a greater role in Japanese
markets than do traditional balance sheet and income statement ratios.
While the
Japanese are not required to prepare an audited cash flow statement with their annual
reports, some Japanese have been preparing Statements of Cash Flows voluntarily since
1959.
In a survey conducted in 1959 by Kyojiro Someya, he obtained data reflecting the
degree to which the Japanese utilize the various statements. Table 3.1 contains the results
of his survey. Table 3.2 depicts the number and percentage of companies making use of
cash flow statements. It should be noted that of the 437 companies surveyed, all but one
prepared and used such statements. The table indicates the percentage o f respondents
who used cash flow statements. The size column refers to the yen amount o f capital stock.
This is noteworthy since, unlike the balance sheet and income statement, there is no law
that requires its preparation. Table 3.3 identifies the various usages o f the cash flow
statement and by whom.
Someya’s survey revealed that as early as 1959 the major users of cash flow
statements were bank creditors, not shareholders. This is not surprising given the
ownership structure in Japan, as well as the Keiretsu networking. Someya’s research
reveals that as of 1996, not much had changed as to the usage of the cash flow statements.
What is of notable interest is how the Japanese use of the cash flow statement
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36
drastically differs from that of the United States.
The Japanese appear to be less
concerned with the cash flow statement as a predictor or tool for the individual investors.
Rather; the statement of cash flow is used as a tool for management. This is one of those
major cultural differences that the United States’ financial analysts, investors and
researchers must keep in the forefront when reaching analytical conclusions.
While this research attempts to ascertain if there is a relationship between cash
flow ratios and security returns, it does so knowing that the Japanese, historically at least,
have had less overall interest in financial markets than individuals here in the United
States.21
Size*
No. of respondents
73
No. of Companies
usinc statements
68
A
Percent
93.2
B
66
63
95.5
C
101
96
95.0
D
113
107
94.7
E
84
70
83.3
Total
437
404
92.4
“Source: The Use of Funds Statement and Cash Flow Statements in Japan:
Kyojiro Someya, 1996
Size in
Capital Stock
A
B
C
D
E
Over ?20 billion
710-19.9 billion
? s – 9.9 billion
? 2.5 4.9 billion
Under ? 2.5 billion
21 This is true even though the Nikkei market is the second largest stock exchange in the world
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37
Here in the United States, it was not until 1987 that the Financial Accounting
Standards Board of the Financial Accounting foundation published Statement of
Financial Accounting Standards No. 95 (SFAS 95), “Statement of Cash Flow”, which
became mandatory in financial statements filed for fiscal years ending after July 15, 1988.
Although it has been over a decade since this rule went into effect, little empirical
research has been conducted concerning its impact on security returns. Furthermore, little
usage of the statement ratios is applied in comparison to the balance sheet and income
statement.
Table 3.2
Cash flow statements: intended parties
Group Size
Management
Stockholders
No.
%
No.
A
70
95.9
B
66
C
%
Securities
Reports
No.
%
No.
%
0
0
51
69.9
35
47.9
100
0
0
33
50.0
29
43.9
100
100
1
1.0
52
52.0
44
44.0
D
111
98.2
0
0
53
46.9
54
47.8
E
84
100
1
1.2
43
51.2
41
48.8
Total
431
98.8
2
0.4
232
53.2
203
46.6
Source: The Use of Funds Statement and Cash Flow Statements in Japan:
Kyojiro Someya, 1996
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Banks
38
Table 3.3 lists the type of cash flow ratios that can be derived from using a cash
flow statement, while table 3.4 illustrates the type of cash flow ratios which can be
derived from other types of financial statements. It is evident that a firm’s solvency is
more accurately determined from cash flow statement ratios than from the other
statements.
Table 3.3
List of traditional Cash flow Ratios
From Cash flow statements
Ratio Name
Ratio Equation
Ratio Purpose
Operating Cash Flow
(OCF)
Cash flow from
operation/current liabilities
Funds flow converge (FFC)
EBITDA/(interest + taxadjusted debt repayment +
Tax-adjusted preferreddividends)
Cash flow from operations +
interest paid + tax paid
/interest paid
Operating cash flow-cash
dividends/Current debt
Cash flow from
operations/Capital
expenditures
Company’s ability to
generate resources to meet
current liabilities
Coverage o f unavoidable
expenditures
Cash Interest Coverage
(CIC)
Cash current debt coverage
(CDC)
Capital Expenditure (CE)
Total Debt (CLTD)
Cash flow from
operadons/Total debt
Company’s ability to meet
interest payment
Company’s ability to repay
its current debt
Company’s ability to cover
debt after maintenance or
investment on plan and
equipment
Company’s ability to cover
future debt obligations
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39
Table 3.4
List of cash flow from other
Financial statements
Ratio
Calculation
Cash flow liquidity Cash + marketable
ratio
securities + Net cash
provided by operating
activities) /current
liabilities
Cash flow margin
Net cash provided by
operating activities/ Net
sales
Cash flow per
share of common
stock
Net cash provided by
operating
activities/Average
number of shares of
common stock
outstanding
Purpose
Test of short-term,
debt-paying
ability
Source
Cash flow
statement and
Balance Sheet
Cash flow
Measure of the
ability of a Arm to statement and
translate sales into Income Statement
cash
Test of ability to
Cash flow
pay dividends and statement and
liabilities
Balance Sheet
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40
A clearer picture o f Japan’s accounting practices and procedures emerges when
one examines certain cultural aspects of Japan.
It is well known that Japanese
businessmen do an enormous amount of networking.
For a long time American
businessman did not understand this phenomenon.
Furthermore, Americans often
question the concept of consensus building when making business decisions. The answer
to these and similar questions lie in understanding Japanese culture.
Bloom et al. (1994) explores this concept and how it relates to Japanese
accounting.
They examine the interrelated issues of harmony, trust, and conflict
resolution as means of exploring how culture influences ones’ interpretation of
accounting. They begin by exploring a model introduced by McKinnon (1991).
McKinnon emphasizes that the Japanese values of harmony can be evident in its
accounting. McKinnon’s model stresses: Japan’s extremely low incidents of law suits to
resolve disputes and almost non-existence o f independent auditors; along with a
centralized and governmental control of Japanese accounting which relate to Confiician
ideas of the moral governance, and the group consciousness among insiders.
Bloom et al. further comments that “harmony” as the sole source of Japan’s
economic success would be superficial and misleading. This researcher agrees with
Bloom et al.
The discussion of “harmony” is interjected here only to serve as an
illustration of the impact o f culture upon accounting.
This impact of culture can be seen
in the group o f corporations known in Japan as the keiretsu.
Ricks (1993) explores the benefits of domestic vertical and horizontal strategic
alliances in competing with the Japanese keiretsu. He believes that in order for U.S.
business to compete with Japanese businesses the U.S. businesses must explore the
benefits of domestic vertical and horizontal strategic alliances. Ricks believes these
alliances are mandated due to the international cartels and Japanese keiretsu. In Ricks’
opinion, non-economic paradigms need to be accentuated.
It is Ricks’ belief that Japanese market success is accompanied by an approach to
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41
channels that emphasize relationships among businesses. These relationships are referred
to as keiretsu. Although the keiretsu organization is discussed in detail in chapter two, it
is addressed here to emphasize its cartel-like characteristics. The keiretsu is believed to
have come about due to the culture of Japan. Many believe that it is the steep influence of
Confucianism which explains Japan’s collective attributes as well as the work ethics
demonstrated by corporate employees.
Ricks discusses the need for U.S. style keiretsu and believes that there are
particular benefits to such alliances. Among such benefits are: (1) financial protection,
(2) profitability, (3) future stability and growth, and technology sharing to list a few.
Ricks concludes that domestic firms need to conduct organization research on how they
can strengthen strategic alliances among domestic businesses.
Tilton (199S) states in his research that the United States has consistently
pressured Japan to enhance its Anti-Monopoly Law as it is viewed that the existence of
the keiretsu violate the U.S. definition of monopoly. Tilton believes that these industry
cartels have tacit and governmental support.
Flath (1994) cites a 1957 U.S. Supreme Court ruling which found Du Pont
violated antitrust laws by holding 23 percent stock interest in General Motors. However,
these types of inter-company holdings are commonplace in Japan. Robert L. Cutts, in an
article for the Harvard Business Review, states, “Hundreds of cartels established to set
prices, rationalized industries, and depressed markets, for example, have been permitted
by law, and even supervised by the government.” (Cutts, 1992).
The fact that the Japanese government sanctions the existence of the keiretsu, and
also determines Japan’s GAAP, leads to the conclusion that accounting standards in
Japan are determined to some degree by the keiretsu.
Undoubtedly, the keiretsu is one of the dominant aspects of Japan’s economy and
culture.
Therefore, it is pertinent that research conducted upon Japanese firms be
examined giving deference to Japanese culture and economic environment.
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CHAPTER 4
EXTANT STUDIES OF CASH FLOW INFLUENCE UPON SECURITY RETURN
VALUATIONS OF KEIRETSU FIRMS AND HYPOTHESIS FOR THE STUDY
Prior studies of the fundamental financial analysis that assist in explaining the
stock valuation of firms focused mainly on U.S. firms. As discussed previously, the
overwhelming thrust of investors into the global market requires some investigation into
the relevance of these fundamentals as they relate to foreign firms. To date, little research
has been done in this area as it relates to Japanese firms in general, and none for keiretsu
firms specifically. In addition, none of the prior researchers discussed their findings in
light of the cultural context of Japan.
4.1 Financial Fundamentals Impact on the Price of Japanese Securities
Although researchers have begun exploring the application of U.S. research
models to Japanese firms as it relates to accounting, much more research is needed in a
variety of areas. None of the prior researchers focused exclusively on keiretsu firms, and
none examined their results in light of Japanese culture. What other variables might
influence stock returns?
Does belonging to the keiretsu change the application of
fundamental variables? Would an understanding of Japanese culture lead to a different
interpretation of the data results? This research adds to the growing and much needed
body of empirical study.
Other researchers who have examined Japanese firms primarily focused upon
price earnings and firms’ profitability. Two main studies investigated whether certain
U.S. fundamental financial analysis could be applied to Japanese firms. The Chan,
Hamao, and Lakonishok (1993) and Charitou, Chubb and Andreau (2000) studies both
address the impact of fundamental accounting variables upon security returns on Japanese
firms. This study extends their work by adding a variable that is a long-term measure o f
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43
security value.
4.1.1 Chan et al.*s Research
Chan et al. (1993) performed a study, which examined the relation between equity
returns in Japan and fundamental variables. Their study added to the relatively small
body of work in this area. The researchers’ findings proved that there is a significant
relation between fundamental variables and expected returns in Japanese markets.
Chan et al. used various methods to estimate the effects o f earning yield, company
size, book-to-market and cash flow on Japanese stock prices over the period o f 1971-88.
Chan et al. focused upon manufacturing and non-manufacturing firms. Prior research
which explored Japanese firms’ profitability only looked at manufacturing firms.
Of the four variables Chan et al. used in their model, the book-to-market ratio
proved the most important influence on returns. The researchers also found that the same
factors affect the Japanese market that affects U.S. markets. They cite work conducted by
Fama (1991) and French (1992), which proved the book-to-market is a predictor of stock
returns in the United States. Chan et al. believed that adding the earnings variable would
help in assessing whether differences in Japanese accounting regulations would be
evident in stock returns. For example, the fact that most companies use accelerated
depreciation methods for financial reporting would lead one to expect an impact on the
firm’s earnings and thus security returns.
Chan et al. used monthly returns and market capitalization from a self comprised
database as well as information obtained from Daiwa Securities Co. Ltd. They chose to
conduct their research at the portfolio level. Their findings conclude that a significant
relationship exists between returns in Japanese markets and several fundamental
variables.
The current study borrows the book-to-market variable from their model and adds
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44
it to Charitou et al.’s model. One observation about Chan et al.’s research is that their
data includes what is referred to as the “bubble period”. A discussion of the importance of
this fact is discussed in detail below.
4.1.2 Charitou et al.’s Research
Although Chan et al.’s research provides added empirical data, their research does
not focus on keiretsu firms specifically. It could be argued that these results would not
hold true for keiretsu firms. The researchers admit that other variables may also influence
stock returns. In spite of these criticisms, their body of work should be credited with
providing some of the pioneer research in applying U.S. fundamentals to Japanese firms.
The second study of interest was conducted by Charitou, Clubb, and Andreou
(2000). Charitou et al. added to the body of research concerning the association of
earnings and cash flow with security returns by using a Japanese dataset for the period of
1984-93. They hypothesized that (1) earnings and cash flows are jointly associated with
security returns, and (2) the association between cash flows and security returns increase
when earnings are transitory. Their study provided empirical evidence that (1) cash flow
has informational content in explaining security returns and (2) that cash flow plays a
more important role in the marketplace when earnings are transitory. They conclude that
Japanese investors utilize earnings and cash flows in their pricing of equities as is done in
the United States.
Charitou et al. argues that the difference in reporting requirements between the
United States and Japan account for the current research data that reveal a weak linkage
between other variables (other than book-to-market) and the return of securities in Japan.
In the aforementioned research, while earnings were included as a variable they
were statistically insignificant in predicting security returns for Japanese firms. This
research agrees with Charitou et al.’s observation that this is partially due to the fact that
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45
Japanese reported earnings and management forecasts have information content around
earnings announcements.
With this is mind Charitou et al. set out to prove that earnings would have a
greater impact upon security returns if “transitory earnings” were captured in the research
model. Charitou et al. sampled firms selected from the Global Vantage database for the
years 1985-1993. The analysis focused upon security returns and their relationship to the
level changes of earnings and cash flow measures.
Charitou et al.’s model
RET.it =b.0 + b,1 E.it + b,Ee.
+ b,CFOe
+ b4 CFOe.it + beE.
* D + b,E.
. D + b,7CFO.it *D +
2
it
3
it
5 it
6 it *
b8CFO.it *D + eit
This study, while building on Charitou’s model, also differs from Charitou et al.
(1) by including additional variables, and (2) by changing the years of the dataset.
Charitou et al.’s research included what has come to known as the bubble period of
Japan’s economy. The current research excludes the bubble period by including firms for
the period of 1994-1999. The bubble period in Japan is usually referred to as the period
between 1986 and 1987. It is called so because that is when the economy is said to have
expanded just before the recession and many economist believe that the equity stocks
were overpriced. Therefore, this study purposely excludes the bubble period. In addition,
it is pertinent to keep this in mind while reviewing results of research that include this
period.
Charitou et al. (2000) provides significant research data in this area. However,
even though it is the most recent research, it was conducted on firms from 1985-1993.
Both Charitou et al. and Chan et al. use databases inclusive of Japan’s bubble
period and neither focus specifically upon keiretsu firms. Furthermore, while Charitou et
al. do a good job of detailing the similarities and differences between U.S. and Japanese
accounting reporting methods, neither address significant cultural aspects which may
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46
yield additional understanding o f their research results.
This hypothesis was tested to some degree using only U.S. firms (Bowen et al.
1986; Bernard and Stober, 1989) yielding mixed results.
Like Charitou et al. it is
believed that financial reporting practices may influence the usefulness o f accounting data
in Japan. Unlike their study, however, this aspect is explored through a discussion of
Japanese culture. This research captures the cultural aspect by including an additional
variable, cash flow from long-term debt, and by focusing only upon keiretsu firms,
particularly in light of the research conducted by Choi et al. (1983)
4.2 Hypothesis Developments
Although researchers have begun exploring the application of U.S. research
models to Japanese firms as it relates to accounting, additional study is needed in a
variety of areas. None of the prior researchers focused exclusively on keiretsu firms, and
none examined their results in light of Japanese culture. What other variables might
influence stock returns? Does belonging to the keiretsu change the application of
fundamental variables? Would an understanding of Japanese culture shed a different
interpretation of the data results? This research adds to the growing and much needed
body of empirical study. It does so by building upon research conducted by Charitou et
al. and by expanding their model.
4.2.1 Hypothesis of Cash Flow and Security Valuation of Keiretsu Firms
The research hypothesis to be tested in the present study stated in alternative form
is, Hypothesis: There is a significant relationship between operating cash flows,
earnings, cash flow to long-term debt ratio, book-to-market, and security returns.
This hypothesis predicts that empirical data will reveal that there is a significant
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47
association between operating cash flows, earnings, and cash flow from long-term debt,
book-to-market values, and a keiretsu Arm’s security value. Various regulatory bodies in
the United States, United Kingdom, Australia, and the International Accounting
Standards Committee believe that information concerning cash flows, along with
earnings, play a signiflcant role in determining share value.
The purpose o f this hypothesis is to explore the significance of cash flows in
explaining Japanese keiretsu Arm’s security value and thus provide support for Anancial
analysts as well as regulatory bodies. The empirical research will show that similar to
U.S. Arms, fundamental Anancial variables signiAcantly influence keiretsu Arms’ security
value. Importantly, in light of cautions provided by Choi et al. (1983), the data is viewed
in the context of the Japanese culture.
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CHAPTER 5
THE STUDY: DATA AND SOURCES, THE SAMPLE, EMPIRICAL MODEL
AND METHODOLOGY
A sample of 100 Japanese firms over a five-year period was conducted. The data
for this study came from public sources. Sample firms were selected from the Western
Investor Database (1999 version) using the following criteria: a) availability of data to
calculate cash flow ratios, and b) availability of market price and dividends data needed
to calculate security returns for the period 1994-98.
A listing of the firms used in this
study is provided in the appendix.
The sample period for calculating cash flow and security return is March 1994 to
October 1999. This period was chosen due to the accessibility of data and because this
period was a recessionary period for Japan. This selection procedure resulted in 2,000
firm-year observations. No classification as to industry, firm size, or level of assets was
used in selecting the firms.
S.1 Variables and Descriptive Statistics
This analysis centers on security returns and their relationship to fundamental
financial analysis variables.
The variables used in the present study are defined as follows:
(1) Security returns (secret): this represents a firm’s annual security return for the
fiscal year and is defined as cash dividends, plus capital gains (losses), divided by
security price at the beginning of the fiscal year.22
22 The majority of firms in Japan have March year ends. This is in contrast to U.S.
firms which typically have December year ends.
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49
(2) Operating earnings (EARN): this represents net income before extraordinary
items, discontinued operations, special and non-operating items.
(3) Cash flow from operations (OCF): this represents operating earnings adjusted for
all non-current accruals,23 plus net changes in all working capital accounts related
to operations, except for changes in cash, marketable securities, and debt in
current liabilities.
(4) Cash flow to long-term debt (CFLTD): this represents a company’s ability to
cover future debt obligations.
(5) Book-to-market (BKTMKT): this is the book value of equity including paid-in
capital and reserve accounts per share divided by price per share.
Panel A of Table 4 presents descriptive statistics (mean, median, and standard
deviation, upper and lower quartile, minimum, and maximum) for all variables (level
and changes of earnings, cash flows and security returns used in the regression
models. Descriptive results indicate that (1) the variability of cash flow measures is
greater than the variability of the earnings measures, and (2) the mean and median for
the cash flow levels variable are greater than the equivalent earnings level.
Panel B of Table 4 presents Pearson correlation coefficients for all levels. The
results indicate that the correlation between returns and earnings is greater than the
association between returns and cash flows for keiretsu firms.
These Japanese
descriptive statistics results and correlation results are consistent with prior U.S.
evidence. Descriptive results indicate that the variability of the cash flow measures is
greater than the variability of the earnings measures.
23 This would include but not be limited to depreciation, amortization, deferred
taxation etc.
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so
Table 4.
Panel A: Descriptive Statistics (N = 400)
Mean
Standard
Deviation
0.234
EARN
0.915
0.337
OCF
0.689
RET
-0.733
0.392
0.307
CFLTD
0.131
0.682
BKTOMKT
0.796
Maximum
0.117
0.118
0.131
0.116
0.549
Minimum
-0.140
-0.318
-0.178
-0.191
0.499
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51
Panel B: Correlation Analysis (N = 2,000)
EARN
OCF
RET
CFLTD
BKTOMKT
EARN
1
OCF
.684
1
RET
-.038
.053
1
CFLTD
-.002
-.002
-.042
1
BKTOMKT
.055
.005
-.265
.011
1
S. 1.2 The Empirical Model and Methodology
A multiple regression model was used to test for the effect of cash flow, earnings,
cash flow from long-term debt, and book-to-market upon security returns o f Japanese
keiretsu firms.
Charitou’s model was modified to include cash flow ratios for solvency
and liquidity. This was done due to the culture and accounting philosophy in Japan.24The
relationship of security returns and the various cash flow ratios is tested using the
following model:
Model: SECRET,it = „0 + I OCF,it + 2CFLTD,it+ 3 BKTOMKT,it+ 4 EARN,it +
Where:
SECRET = security returns
OCF = Operating cash flow
24 It is well researched and documented that Japanese managers are less concerned with
short-term profits and more concerned with long term market share. As a result many
researchers here in the U.S. have missed the mark by focusing their research on Japanese
profitability ratios. Therefore, this research attempts to address this issue by examining
the firm’s level of liquidity and solvency.
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52
CFLTD = cash to total debt
BKTOMKT = book to market
EARN = firms earnings
= standard error
t •=year
i “ firm
Hypothesis 1 is tested by regressing the security returns on the above variables. Using
the t-statistics for the coefficients. This was done in keeping with the underlying
understanding that there are cultural differences that impact accounting standards and
thereby financial reporting methods and contents.23
The hypothesis was tested by regressing OCF, EARN, CFLTD, and BKTOMKT,
systematically against the dependent variable SECRET. The first model consisted of
regressing cash flow long-term debt against security return. The second model consisted
of regressing cash flow against security return. In the third model, the ratio book to
market was regressed.
The Dependant Variable
Security Returns Valuation
The rate of return on a security is the natural extension of the notion of an interest
rate to securities with randomness. The rate of return over some time period is the change
in value divided by the value at the start of the period. For example, for a stock paying a
dividend, the rate of return is
Rt= P L+ D L- P LL = —
Pt -1
+
Dt
—
25 Please refer to Choi et al. (1983) for a detail discussion of these differences
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53
Where:
R = rate of return
P = principle investment
D = dividend
t = time
In the last expression, the first term is the capital gain (loss), and the second term is
the income.
The rate of return is often stated in financial prospectus. This rate is
indicative of what earnings an investor would expect to receive. This is important to our
study, as investors would expect to receive high rate of returns. Recently, managers have
been under pressure by financial analysts to assure that firms have high security values.
This research is vital in ascertaining to what degree cash flows influence those returns.
Since cash flow statements are not mandatory in Japan, it would therefore be difficult for
an analyst to make such a determination. The results of the analysis and a comparison to
actual hypothesized outcome is the subject of the next chapter.
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54
CHAPTER 6
RESEARCH RESULTS AND DISCUSSION
Chapter 5 discussed the design of the research and described the empirical model
used for this study. It described the approach used to obtain firms used in the study, and
the study period. It also described the test of the hypothesis outlined in Chapter 4.
This chapter discusses the results of the full analysis for security returns. The
group of firms was selected based on the availability of data and classification as a
keiretsu firm. The majority of firms had data for the years 1994-1998. A few of the firms
also had data for 1993 and 1999. In situations where there was no data for 1994 but data
for 1999, those firms were included. Appendix B has a listing of all of the firms used in
this study.
6.1 Empirical Results of the Analysis
The study investigated whether there is a significant relationship between several
financial fundamental variables and security returns for keiretsu firms. Using multiple
regression analysis, it was hypothesized that no significant relations existed between
security valuation and cash flow, earnings, cash flow from long-term debt and book-tomarket ratios.
Table S.l presents pooled results for the empirical model that indicate that cash flow
ratios are positively associated with security returns. The coefficient o f cash flow for
long term debt over the period of 1994 – 1999 is -1.196 and is statistically significant at
p= 0.05 (t = .332). The R2 is .02.
In summary, consistent with prior U.S. and international evidence, cash flow has a
greater affect upon security valuation than does earnings and the cash flow for liquidity
and debt. These results provide support for the hypothesis and indicate that operating
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55
cash flow ratios are as highly valuable as accrual components. What the data fails to
address is the usage of cash flow ratios independent of their impact upon security returns.
This is to be expected due to the high correlation between the variables and is consistent
with results from other researchers.
Future research should ascertain to what degree foreign as opposed to domestic
analysts use this data. Nonetheless, the research data reveals that while cash flow alone
by no means accounts for security returns, it does, indeed, add value. The results add
further support for using BKTOMKT ratios as it provides the highest level o f significance
to security returns.
What may be concluded is that investors need all three financial statements and
that it would be an error to omit any one of them. Data results also reveal that the
Japanese business culture, although different from that of the United States could also
benefit from the publication of cash flow statements.
Financial analysts as well as
auditors, should be mindful of the use of financial statements themselves apart from their
predictive powers.
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56
Table 5.1
Model
1
R R Square Adjusted R Std. Error Change
Square
of the Statistics
Estimate
R Square F Change
Change
.332
.110
.096
.3730
.110
8.048
Model Summary
Predictors: (Constant), CASHFLOW, CFLTD, BKTOMKT, EARN
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Sig. F
Change
.000
Table 5.2
____________ sec/ret BKTOMKT
Pearson
sec/ret
-.265
1.000
Correlation
BKTOMKT
-.265
1.000
-.042
.011
CFLTD
-.047
EARN
.047
CASHFLOW
.062
-.063
.000
Sig. (1sec/ret
•
tailed)
BKTOMKT
.000
CFLTD
.199
.410
/EARN
.175
.173
.104
.110
CASHFLOW
N 400
CFLTD_______ EARN
-.042
.047
CASHFLOW
.062
.011
1.000
-.007
.077
.199
-.047
-.007
1.000
.831
.175
-.063
.077
.831
1.000
.110
.410
.
.173
.443
.443
.062
.104
.062
.000
.000
Correlations
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58
Table 5.3
Coefficients
Standardized
Coefficients
T Sig.
95%
Confidence
Interval for B
(Constant)
BKTOMKT
-.210
-.219
-4.093
-.210
-.178
Upper
Bound
.168
-.063
CFLTD
-.056
-1.162
-.005
.001
CASHFLOW
-.233
-3.924
-1.753
-.583
EARN
.082
1.433
-.002
.013
Beta
Lower Bound
a Dependent
Variable: sec/ret
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59
6.2 Empirical Results in Light of Japan Cultural Understanding of the
Keiretsu
Admittedly, this section is anecdotal and not thoroughly empirical. This can be
done based on research conducted by researchers such as Choi, Hofstede, and Gray.
It can not scientifically be said that keiretsu firms perform better or worse than nonkeiretsu firms, for no comparison was made. Such comparison should be done in future
research. Since there is little research data on Japanese firms in English, this research
serves as a much needed beginning.
The research does establish that U.S. fundamental financial tools do work for
Japanese firms.
Since this has been established, further research can be conducted.
However, the question still remains, given what is known about Japanese culture and its
impact upon the formation of the keiretsu, how can the empirical data best be interpreted?
6.2.1 Sociological and Economic Cultural Impact
This section discusses the sociological and economic makeup of Japanese firms
and the political environment which have bearings upon the relationship between a firm’s
security returns and the fundamental variables used in the above empirical study.
6.2.2 Usage of Financial Statements
The independent variables used in this study are the same as those that would
have been used in U.S. firms. The underlying assumption implied, is that these variables
hold the same level of importance to Japanese investors as they do to U.S. investors and
creditors. Variables used in the model are obtained from external financial statements.
Therefore, in order to ascertain the level of importance of these variables to Japanese
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60
investors and creditors, a review of the importance o f external financial statement is
necessary.
It is generally believed that the overwhelming amount of emphasis placed upon
the external financial reporting function of accounting is due to the importance of
industrial capital accumulation from the private sector in relation to the economic
development of our modern-day society.
The socio-economic condition in Japan prior to the Second World War did not
necessarily demand that accounting should have an important role in disclosing such
financial information. Because Japan’s vital industries are members of the keiretsu, and
the ability of Japan to produce internal capital markets, the function of accounting to
provide financial information to investors is not understood by most people. Japan’s
capital market is not capable o f supplying sufficient industrial capital. Professor Jaruga
(1988) states: “The functions of accounting corresponds to the evolution of the
socioeconomic system in the [socialist countries].”
Therefore, it is concluded that although the fundamental variables do influence
security returns, it will not have significant importance to the Japanese until they divert
their efforts to establish internal capital markets.
To date, the Japanese have been
successful in formulating robust external capital markets. Japan is often noted as having
the largest savings rate by individuals in the world.
In recent months, economists (U.S. particularly) have expressed their concern
about Japan’s inability to have its citizens stimulate their economy thorough spending and
investing. If the individual investor in Japan is not concerned or is non-existence, the
data from the financial statement although accurate, is insignificant.
Knowing the importance of securities returns to the investor may lead one to
conclude that the returns of Japanese firms are only important to individual investors in
those firms. This would be a mistake. Recently, Japan has begun opening its market to
outside investors. In addition, many individuals in the United States invest in Japan
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61
through mutual funds. Therefore, U.S. analysts must be aware of the lack of importance
placed on this information in Japan.
6.2.3 Political and Economic Culture of Japan
There is a large degree of mutual interest between government and corporations in
Japan. Various governmental ministries collect a tremendous amount data and supply
accurate economic forecasts, which can be utilized by businesses for planning. This
reinforces the emphasis on long-term growth, and thus accounting conservatism.
The
centralization and governmental control of Japanese accounting impacts the importance
placed upon financial data.
6.2.4 Social Culture Impact Upon Business Culture
The Japanese work force has been portrayed as being group conscious and
extremely loyal to the company (McKinnon, 1986). Japan’s value of harmony and its low
dependency on lawsuits are both related to Confucian ideas o f the moral governance.
It is this make up that accounts for the reluctance of firms to publish security return data.
Although firms focus upon harmonization and loyalty, this loyalty is to the firm. The
result is a very competitive environment between firms in Japan, subsequently, managers
are reluctant to publish external financial data.
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CHAPTER 7
SUMMARY AND CONCLUSION
This dissertation discusses the impact o f security return and fundamental variables
of Japanese keiretsu firms. The impact was assessed by regressing security return upon
four fundamental financial variables. In addition, those results were analyzed through the
prism of Japanese cultur…