Don’t Overlook Accounting Comparability
Accounting decisions involve significant judgment. After all, US GAAP gives firms the discretion to choose among alternative accounting methods when it comes to inventory valuation, depreciation calculation, derivative accounting, etc. It also gives managers flexibility in recognizing and measuring contingent liabilities and other transactions.
While accounting chiefs may appreciate having more flexibility in their accounting decisions, investors tend not to be thrilled when firms make accounting choices that are atypical for their industry. Indeed, when firms exhibit lower accounting comparability relative to their peers, the stock market values their earnings at a lower rate. That’s among the conclusions of “Accounting Comparability and the Value Relevance of Earnings and Book Value,” the forthcoming study Bingyi Chen, Guannan Wang, and I co-authored for the Journal of Corporate Accounting & Finance.
The stakes are high: Low accounting comparability can be costly for both firms and managers. Why? Because they have economic benefits tied to that comparability. A stronger link between stock valuation and earnings under high comparability may boost a firm’s equity financing capacity as well as its managers’ equity compensation packages.
Why do investors prefer comparable accounting? First, by facilitating benchmarking across firms, higher comparability ensures that investors can access more relevant peer and overall industry information. Second, it lowers investors’ firm-specific information processing costs and thereby facilitates a more precise valuation of financial information.
To test accounting comparability in investor valuation decisions, we estimated a value relevance model using over 31,000 observations between 1996 and 2015. In this model, a firm’s stock price is a function of its earnings, book value of equity, and their interaction with accounting comparability.
Our estimates show that the average firm’s stock price rises by $5.40 for a $1 earnings per share (EPS) increase. But the valuation of earnings declines significantly when managers use more atypical accounting choices. For firms with low accounting comparability, we estimate the stock price goes up by $4.04 for a $1 increase in EPS. This represents a 25% reduction in earnings’ value relevance.
On the other hand, following industry accounting practices closely appears to pay off. Unlike their low comparability counterparts, high comparability firms can see their share price rise $6.76 with a $1 EPS increase.
Prior research demonstrates parallel results. Analysts, for instance, tend to avoid covering firms with low comparability. After all, the information processing costs are higher for such firms due to the difficulty of benchmarking and understanding their financial statements. Moreover, analysts tend to produce more reliable earnings forecasts for firms with high versus low accounting comparability.
Our findings highlight an important caveat: Investors do not consider accounting comparability in a vacuum. They assess it in conjunction with financial statement reliability. Thus, to fully realize the valuation benefits of comparability, firms must have high-quality reporting systems and financial statements in the first place.
We examined three important indicators of financial statement reliability: the presence of strong internal controls, transparency in financial reporting, and auditor industry expertise.
Sound internal financial reporting controls is a prerequisite if the value relevance benefits of accounting comparability are to be achieved. The lack of strong internal controls over financial reporting leads to investor skepticism and questions about whether disclosed accounting policies are applied properly. Notably, we find that reporting an internal control material weakness eliminates any additional value relevance of earnings that can be obtained under high accounting comparability.
Even if firms have sound internal controls, accounting comparability would matter less to investors absent financial reporting transparency. Accrual accounting, by definition, has a discretionary component — for example, allowance for doubtful receivables and estimated warranty reserves. But, we demonstrate that reporting consistently high levels of discretionary accruals compromises a firm’s financial reporting transparency and thereby reduces the benefits of accounting comparability. That is, if investors have less trust in the reported numbers, comparability becomes less of a factor in their valuation decisions.
Another way to build trust with investors? Hire auditors with significant industry expertise. Our results show that accounting comparability enhances the value relevance of earnings more when the firm’s auditor is a “city industry specialist” that also audits the firm’s local industry peers.
Our study’s key takeaway is that there is an interplay among accounting comparability and other financial reporting characteristics. Financial statement preparers and other stakeholders should know that high accounting comparability may not yield economic benefits without transparent and reliable financial reporting. So accounting chiefs should pay close attention to the accounting policies of their industry peers and work to improve the quality of their companies’ financial reporting system.
If you liked this post, don’t forget to subscribe to the Enterprising Investor.
All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.
Image credit: ©Getty Images / abzee