Our first tests are concerned with the incremental explanatory power of book value and
residual earnings. As in Collins et al. (1997) we compare the results of three regression
equations to address the question of relative and incremental explanatory power. Equation
(2) below provides the most parsimonious empirical specification of the residual earningsmodel on a per share basis (the horizon is only one period). Current period residual
earnings is the proxy for future expected residual earnings. Residual earnings are estimated
by subtracting an estimate of normal (expected) earnings from reported earnings. Expected
earnings is the product of the estimated rate of return (r) and book value. Like Frankel and
Lee (1999), we derive the estimated rate of return from interest rates in the International
Financial Statistics Yearbook published by the International Monetary Fund (1997).
Frankel and Lee (1999), however, are able to calculate a risk-adjusted return by adding
a risk premium to long-term government bond rates Government bond rates are not
available for four of the countries; therefore, we use commercial lending rates. Conceptually,
this rate is the sum of a riskless rate and the average commercial lending risk
premium. In the residual earnings model, book value and firm value are taken at time t
while future abnormal earnings are for periods after time t. In our empirical analysis
residual earnings (REt) are for the period ending at time t. Hence, as in Bernard (1994) and
Collins et al. (1997), current earnings is a proxy for expected future earnings.
Our first tests are concerned with the incremental explanatory power of book value and
residual earnings. As in Collins et al. (1997) we compare the results of three regression
equations to address the question of relative and incremental explanatory power. Equation
(2) below provides the most parsimonious empirical specification of the residual earningsmodel on a per share basis (the horizon is only one period). Current period residual
earnings is the proxy for future expected residual earnings. Residual earnings are estimated
by subtracting an estimate of normal (expected) earnings from reported earnings. Expected
earnings is the product of the estimated rate of return (r) and book value. Like Frankel and
Lee (1999), we derive the estimated rate of return from interest rates in the International
Financial Statistics Yearbook published by the International Monetary Fund (1997).
Frankel and Lee (1999), however, are able to calculate a risk-adjusted return by adding
a risk premium to long-term government bond rates Government bond rates are not
available for four of the countries; therefore, we use commercial lending rates. Conceptually,
this rate is the sum of a riskless rate and the average commercial lending risk
premium. In the residual earnings model, book value and firm value are taken at time t
while future abnormal earnings are for periods after time t. In our empirical analysis
residual earnings (REt) are for the period ending at time t. Hence, as in Bernard (1994) and
Collins et al. (1997), current earnings is a proxy for expected future earnings.
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