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International Bulletin of Business Administration ISSN: 1451-243X Issue 10 (2011) EuroJournals, Inc. 2011 http://www.eurojournals.

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The Relationship between Capital Structure Effect on Earnings Response Coefficient for in Tehran Stock Exchange (TSE)
Hossein Panahian Corresponding Author, Islamic Azad University - Kashan Branch-Kashan- Iran E-mail: H.panahian@iaukashan.ac.ir Ali Aminossadati Mastrer of Accounting; Islamic Azad University - Kashan Branch-Kashan- Iran Abstract In this study, capital structure effect on earnings response coefficient (the effect of unexpected earnings on abnormal returns) for of listed companies in TSE is investigated within the time span from 2002 to 2008. The goal of this research is to find the answer to the question of Do investors, analysts and pay attention to the good or bad news derived from the distribution of accounting earnings information and response according to the information? In this study, companys financial leverage is considered as an index for investigating capital structure and two approaches toward defining financial leverage has been utilized: Balance-sheet approach and Income statement approach. For balance-sheet approach, two definitions of the ratio of liability book-value to total assets book-value and the ratio of liability book-value to equity book-value are used. For income statement approach, definition of degree of financial leverage (DFL) is utilized. The sample companies were divided into two groups of high and low level of leverage according to the average of financial leverage during the studied period. Research hypothesis is tested for each definitions of financial leverage twice: once among the whole sample companies and then at low and high levels of financial leverage. Using ANOVA, correlation test and regression analysis for the single hypothesis of this research shows that it is confirmed only at the high level of leverage of the above balance-sheet definitions and is refuted for all the other cases. Keywords: Financial leverage, unexpected earnings, abnormal returns, earnings response coefficient

Introduction
This research, which is categorized among those carried out according to capital market involves the experimental test of the rate of abnormal stock returns affectability from unexpected accounting earnings at earning per share (EPS) announcement and distribution, paying attention to different capital structures in different companies. This research can be important form two aspects: the value of accounting information especially for decision making purposes and determining the rate of streturns affectability from earnings in different capital structures. Earnings response coefficient is measured markets abnormal returns according to stated unexpected earnings components. Scot mentions the following reasons for different reactions of markets abnormal returns to unexpected earnings 96

components: a)systematic risk b)profitability persistence c)earnings quality d)growth opportunity e)capital structure. (Scot, 2003:545). Financial leverage is the important issue when discussing the capital structure. Two approaches can be considered while defining financial leverage: 1) balance-sheet approach 2) income-statement approach. In income-statement approach, the relation between earnings before interest and tax (EBIT) is considered as an independent variable and earnings per share as a dependent variable. In fact, the degree of financial leverage is indicative of EPS change percent in relation with one percent change in EBIT. In balance-sheet approach, the financial leverage is defined according to the liability proportion to equity capital or the liability proportion to total assets. In income statement approach, an increase in EBIT leads to increase in payback and guarantied securities and other current liabilities in a way that most good news of earnings is for creditors in comparison with stockholders. From this viewpoint, earnings response coefficient for the companies with high leverage must be lower than the companies with no or low liability. In balance-sheet approach, the same relation can be seen.For companies with good news in regard to companys asset increase or net assets, first creditors are enjoyed. Thus, higher earnings response coefficient is achieved for the companies with low ratio of liability to equity capital, or low ratio of liability to total assets.

Review of Literature
Collins and kothari has analyzed the relationship between systematic risk and earnings response coefficient and found out that the only reducer for earnings response coefficient is systematic risk (). They also concluded that the factor of growth opportunity rate can positively affect on earnings response coefficient. In fact, their research shows that, like earnings response coefficient of explicit test which can measure the relationship between prices and returns which are implicit in financial valuing model, the earning response coefficient can also be determined considering the systematic risk and growth opportunity variables.(Collins and kothari, 1989:181-143). In an experimental research, Dhaliwal and Fargher analyzed the relation between unexpected earnings and abnormal returns from one hand, and the affectability of financial leverage from the other hand. Their goal was to provide more evidence from which they could recognize and determine the effective factors on pay earnings response coefficient. Considering their analysis, the hypothesis indicated that there is a negative relationship between earning response coefficient and financial leverage (as an index). Therefore, sample companies are categorized according to their industry and company size into two groups: 1.the existence of liability in capital structure, companies without liability versus leverage companies 2. Leverage level: low level of leverage versus high level of leverage.The findings show that earnings response coefficient is higher for companies without leverage or those with low level of leverage in comparison with leverage companies or those with high level of leverage. (Dhaliwal and Fargher, 1991:20-41) Dhaliwal and Reynold graded securities and liability ratio to measure the un-solvency risk. Controlling the systematic risk factors and profitability persistence, they proved that in addition to systematic risk , un-solvency risk can also be negatively in effect on earnings response coefficient. (Dhaliwal and Reynold, 1994:412-9) Feltham and Pae investigates the effect of accounting accrual items on earnings response coefficient. Their analysis shows that the unexpected earnings variance is a positive application of created crowdedness by managed accrual items but improving the information about earnings management will not reduce the variance. Therefore,generally, crowdedness around the managed accrual items earnings will not reduce the earnings response coefficient. (Feltham and Pae, 1999:199220) In an experimental research, the effect of environmental potential liabilities on earnings response coefficient was tested by Benjamin Bae and Sami. In this study, they analyzed the notion of environmental potential liabilities according to accounting information and investigated its relationship 97

with earning response coefficients. In order to investigate the subject, they divided the sample companies into two groups: companies with potential responsible (credit) parts versus companies without potential responsible parts. The findings of regression analysis generally proved their hypothesis that is the market understands the crowdedness resulted from the earnings of environmental potential liabilities. Hence, companies with potential environmental liabilities enjoy lower earnings response coefficient in comparison with companies without such liabilities. (Benjamin Bae and Sami, 2005:43-70) Chambers and Koch analyzed the effect of risk on earnings response coefficient. They concluded that there is an important positive relationship, both economically and statistically, between marginal risk and earning response coefficient. The findings show that the future research based on earnings response coefficient with regard to related values must control the marginal risk. For example, two companies with different accounting patterns, have different earning response coefficients because they have different marginal risks due to the fact that each company has its own suitable accounting value pattern in comparison with other companies. (Chambers and Koch, 2004:83) Cheris and Sommers directly related the earning response coefficient with profitability persistence in a semantic form in order to provide another way for interpreting the markets understanding from the transferred information derived from earnings announcement. They found out that the earnings for companies with income growth has higher quality in comparison with companies with cost decrease. Earnings for companies with income growth lasts more and are managed less through the accrual items in comparison with companies with cost decrease. (Cheris and Sommers, 2005:26) Smith investigates the effect of informational risk increase resulted from backdating the stock options on earning response coefficient. Their findings show that companys informational value is reduced after backdating the stock options which results in reduction of earnings response coefficients.(Smith, 2007:198) Cheng Fan-fa has studied the effect of financial risks on ERC in Australia stock exchange especially bank shares have been studied. Using regression analysis, their finding showed that their hypothesis have been approved and there is a positive relationship between the modified abnormal returns according to risk and unexpected earnings yearly changes( Cheng Fan-fa, 2008:101).

Methodology
This experimental research deals with describing the relation between capital structure and earnings response coefficient, using cross-sectional correlation. The methodology of this research is ExposeFacto. The statistical population includes listed companies in TSE and the time span involves from 2002 to 2008. Statistical population was limited according to following factors: 1. Companies must be productive. 2. Their financial year must be finished at the end of the last month of the year. 3. Their shares must be exchanged through stock exchange. The number of companies was limited to 147 in statistical population considering the above mentioned 3 factors from which 66 companies were selected using random sampling and formula. In order to achieve the needed information as well as the companies share price, TSE website, Tadbir pardaz and Rahavard Novin software were utilized. The tests were carried out for he studied period all were done cross-sectionally (i.e. date of the whole period). Thus, all the needed date was gathered and inserted to Excel software. Then the data was inserted into SPSS and was tested and investigated.

Research Hypothesis
The only hypothesis of the research is: there is a significant relationship between financial leverage and earnings response coefficient. 98

Hypothesis Testing Models and Research Variables Measurement


Regression models of this research are linear and the hypothesis based on these models believes dependent variable continuity and the linearality of communicative model between dependent and independent variables. In order to estimate the model parameters, least squares method was used. To test the hypothesis, the following model is fitted:
AR it = 1 + 2UX it + 3 it + 4 Growth
it

+ D it UX it

H0 : = 0

H1 : < 0

ARit= abnormal returns of i company in t year. UXit= unexpected earnings of i company in t year. it= systematic risk of i company in t year. Growthit= rate of growth opportunities which is measured by equity market value divide to equity book-value. Dit= dummy variable: equals one if leverage is higher than average industry. equals zero if leverage is lower than average industry. The elements and variables used in our multi-factorial model and the method of measurement have been explained in table 1. Furthermore, to measure the expected returns in abnormal returns formula, the real returns of the previous year was utilized. In definitions of abnormal returns, the difference between real returns and expected returns is usually considered. To measure the expected returns, capital asset pricing modal is usually used. Yet in a recent research carried out at Allame University it has been proved that there are variables which can predict stock returns better than beta () in TSE. In this research, no sustainable relationship could be seen between and stock returns the same as what capital asset pricing model predict. Moreover, the results were different within different years. Therefore, using the mentioned model for measuring the expected returns may jeopardize research reliability. From the other hand, the results of most previous research indicate that returns behavior is under the control of random patrol process, when the changes of returns are not predictable. Therefore, to measure the abnormal returns of the current year, the difference between the real return of previous year and the current year has been utilized in recent research. Three definitions of financial leverage have been used in this research to test the hypothesis: a) the ratio of total liability book value to total asset book value (balance sheet approach) b) the ratio of total liability book value to equity book value (balance sheet approach) c) the ratio of (DFL) before tax and interest income to before tax income (income statement approach) In each of the three above mentioned definitions hypotheses have been used in two forms: 1. as a dummy- variable at the total sample level 2. as a dummy-variable in categorizing companies in two groups of high and low level of leverage Considering the number of selected sample companies and the seven-year-studied period, 462comany/year was tested for each definition of financial leverage at total sample level. According to average financial leverage seven years for each definition of financial leverage were carried out after categorizing companies into high and low level of leverage. Considering the above explanations, the results of testing research hypothesis for the first definition of leverage at the total sample level, high level and low level of leverage have been shown at rows 1 to5, while rows 6 to 10 are related to the second definition of financial leverage at total sample level, high level and low level of leverage, and finally in third definition of financial leverage, the results of total sample level, high level and low level of leverage are shown at rows 11 to 13 at table 2.

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Hypotheses Test Result


a) At first five rows, models have been fitted according to the first definition. At high level of leverage, models were proved and the null hypothesis is refuted but at the total sample level and low level of leverage the models are not proved. b) At the second five rows, which are related to the second definition of financial leverage the test was carried out at total level and the model was rejected. The next three rows are related to hypothesis testing at high level of leverage in which the model is proved and the null hypothesis is rejected. Finally, at low level of leverage the model is not proved. c) The hypothesis test which was carried out according to income statement definition of leverage, at all levels (total sample level, high level and low level of leverage) the model is not proved. All the above mentioned tests have been carried out at the error level of 5%.

Conclusion
The results show that for both balance-sheet definitions of leverage, there is a negative relationship between financial leverage and earnings response coefficient. But there is no relationship between financial leverage and ERC at total sample level and low level of leverage. Furthermore, for income statement approach, there is no relationship between financial leverage and ERC at all levels. Paying attention to table 2 shows that at high levels of leverage for balance-sheet approach, investors' attention in reaction to unexpected earnings is influenced negatively although weakly but tangibly. The reason why research results indicate no relationship between financial leverage and earnings response coefficient can be explained as follow: 1. Increases and decreases in stock price and TSE index were highly influenced by environmental factors during the years of the test. Little attention to financial reporting by investors, political factors, etc. have generally caused bubble increase and decrease at the market. 2. at less general levels, a large amount of companies' liabilities are related to either received loans from banks or the liabilities to group companies while in most of the countries of the world bank loans are considered at very difficult liability, as Daewoo company which was announced broke when was not being able to pay back some of its bank loans. But Iran is different. There is a good relationship between banks and companies because most of the banks are governmental and those who are not are severely under the control and regulations applied by the government. The government or semi-governmental units are themselves one of big stockholders at TSE. So there is no sever regulations for the purpose of supporting companies (liability deffered). It can be said that bank loans is a skill for the managers in Iran and is the best way of financial support. One of the other main liabilities for accepted companies at TSE is usually liabilities to group companies. This liability is a flexible one and may be mentioned in balance-sheet for several years without any action or plan to pay them back. 3. It is expected that investors react to new information based on the investors' reasonability assumption. But there are several different evidences where investors react to new information more than usual. Regardless of several risky factors in companies, an experimental research in Iran indicates that there can be seen several cases of more than usual reactions among common stockholders in TSE. As kim et al. presented a reason in their research, there may be other non-responding factors which may affect the result of our research. the factors such as the lack of precise measurement of hypothesized notions of fundamental theories in measuring variables and maybe the unsustainability of economical models and also questioning the profitability of fundamental regulations of financial theories(kim et al. ,2002:51) 100

Research Recommendations
1. forcing companies to offer information in addition to common information for example a part called management analysis is added to financial statements in order to measure and analyze the company's operations by the investors and decide reasonably. 2. necessary courses for the stockholders, investors, stock exchange experts and others who are interested by the TSE in order to increase the general understanding, to use the financial reporting better and especially more attention to companies' capital structure. 3. financial statements distributed by TSE and data- base information like Tadbirpardaz and Rahavard Novin do not include most of the important parts of financial statements. TSE reduces some percents of the stock exchange amounts under the name of stock exchange development provision. If more investments are devoted to software parts of stock exchange and the information availability is facilitated and the users become familiar with financial analysis, the investors' reactions can be influenced. 4. the importance of accounting components necessitates that listed companies in stock exchange show their previous financial statements in their websites in order to inform, the stockholders. This information can be helpful in predicting earnings and determining the natural value of share.

Research Limitations
The limitations and problems which existed in different stages of the research and which must be considered at interpreting the research results and its generalization can be mentioned as follow: 1. considering the limitation of the statistical population which are accepted companies in TSE which are productive and their financial years finishes at the end of the year, which are accepted at the stock exchange before the research studied period, generalizing the results to other companies must be done conservatively. 2. the effects resulted from the difference in accounting methods for financial reporting may influence the results which no modification have been done due to unavailability of information. 3. access to the information of the companies was difficult and took a long time. Because our studies period was 7 years and data gathering from TSE was the only informational source, the studied period lasted for a long time. 4. considering the stock exchange situation in 2003 and 2004 (sudden increase of share price) and in 2005 (sudden decrease of share price) and respective increase and decrease in stock returns, the concluding remarks may be under the influence of economical and political situations.
Table 1:
Rows 1 2 3 4 5 6 7 8 9

Variables and How to calculate


Variables Actual Return(Rit) Expected Return (Rpt) Abnormal Returns EPSA EPSp Unexpected earnings (UX) Systematic Risk( ) Growth Opportunity Ratio Financial Leverage How to calculated Pit P it 1 + D R it = Pit 1 Actual return in the previous year ARit = Rit Rpt Based on GAPP Average of forecasted incomes after approved previous financial statement by general assembly UX it = EPSA EPSp

COV ( R m , R i ) 2 Ri
Equity Capital market-value / Equity Capital book-value DFL Liability proportion to total assets Liability proportion to equity capital

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Table 2:
ROWS

Summery of statistical analysis


Controling Variable R2 AdjustedR2 F Model Sig. Dummy variable B Sig. Results

Dependent Independent Approach Variable Variable Financial BalanceAbnormal 1 Leverage sheet(1) Return Financial BalanceAbnormal 2 Leverage-High sheet(1) Return Level Financial BalanceAbnormal 3 Leverage-High sheet(1) Return Level Financial BalanceAbnormal 4 Leverage-High sheet(1) Return Level Financial BalanceAbnormal 5 Leverage-Low sheet(1) Return Level Financial BalanceAbnormal 6 Leverage sheet(2) Return Financial BalanceAbnormal 7 Leverage-High sheet(2) Return Level Financial BalanceAbnormal 8 Leverage-High sheet(2) Return Level Financial BalanceAbnormal 9 Leverage-High sheet(2) Return Level Financial BalanceAbnormal 10 Leverage-Low sheet(2) Return Level Financial Income Abnormal 11 Leverage Statement Return Financial Income Abnormal 12 Leverage-High Statement Return Level Financial Income Abnormal 13 Leverage-Low Statement Return Level *Based on 7 years of observation (2002-2008) *Significant at =.05

Systematic Risk , Growth opportunity ratio Systematic Risk , Growth opportunity ratio Systematic Risk

.007 .048 .047 .045 .019 .005 .079 .079 .070 .017 .005 .029 .015

-0.002 0.032 0.035 0.037 0.001 -0.003 0.053 0.06 -0.058 0.004 -0.003 -0.004 0.003

0.754 2.974 3.913 5.656 1.032 0.602 3.086 4.135 5.537 1.335 0.616 0.884 1.273

0.556 0.02 0.009 0.004 0.391 0.661 0.018 0.008 0.005 0.257 0.651 0.476 0.28

-0.003 -0.049 -0.051 -0.053 0.00 -0.093 -0.089 -0.086 0.001 0.00 -0.003 0.001

0.438 0.021 0.016 .013 0.769 0.295 0.038 0.031 0.03 0.386 0.815 0.11 0.094

null hypothesis is not rejected null hypothesis is rejected null hypothesis is rejected null hypothesis is rejected null hypothesis is not rejected null hypothesis is not rejected null hypothesis is rejected null hypothesis is rejected null hypothesis is rejected null hypothesis is not rejected null hypothesis is not rejected null hypothesis is not rejected null hypothesis is not rejected

Systematic Risk , Growth opportunity ratio Systematic Risk , Growth opportunity ratio Systematic Risk , Growth opportunity ratio Systematic Risk

Systematic Risk , Growth opportunity ratio Systematic Risk , Growth opportunity ratio Systematic Risk , Growth opportunity ratio Systematic Risk , Growth opportunity ratio

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References
[1] [2] [3] [4] [5] [6] [7] [8] [9] [10] [11] [12] Bae , Benjamin .and .H. Sami , (2005) , "The effect of potential Environmental libilities on Earnings Response Coefficients" JOURNAL OF ACCOUNTING , AUDITING & FINANCE, pp. 43-70. Chambers , Dennis J, R N .Freeman and A S Koch , (2004) , " The effect of Risk on price Responses to Unexpected Earnings ", SSRN elibrary.com , 02/19/2010 . Cheng Fan-fa , (2008) , " Effect of Financial risks on the Earnings Response in Australia Bank Stocks " , Journal of Money& Investment and Banking . Cheris, Gia M and G A. Sommers , (2005) , "The Implied Persistence of Unexpected Earnings and the complete Range of ERCs" , SSRN elibrary.com , 03/15/2010 . Collins , D. , Kothari ,S , (1989) , "An Analysis of the Cross-Sectional and Intertemporal Determinants Of Earnings Response Coefficients" , Journal of Accounting and Economics 11 , 143-181. Dhaliwal, D , K.Lee and N.Fargher, (1991) , "The Association Between Unexpected Earning and Abnormal Security Returns in the presence of Financial Leverage" , Contemporary Accounting research, pp 20-41. Dhaiiwal, D and S.Reynolds , (1994) , "The effect of the Default Risk of Debt on the Earnings Response coefficient" The Accounting Review, pp412-419. Feltham, G A and J .Pae , (1999) , "Analysis of the Impact of Accounting Accrualls on Earnings Uncertainty and Response coefficient", JOURNAL OF ACCOUNTING , AUDITING & FINANCE, pp199-220 . Kim , Yeo , Hwan ,Willett. Roger J and Jee In Jang , (2002) , "Default Risk As a Factor affecting The Earning Response Coefficient" ,SSRN . Scott, William R., (2003) , "Financial Accounting Theory" , Third Edition , Torento , Prentice Hall , pp 91-173. Smith, David B., (2007) , "The Effect of Backdating on Earnings Response Coefficient" , SSRN elibrary.com , 04/21/2010. Tajvidi, Elham , (2006) , " Relationship between Accounting variables and stock returns in TSE ", M.A Thesis ,University Allame Tabatabaee, Faculty of management and Accounting , Tehran.

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