- Accounting decisions involve significant judgment, and US GAAP gives firms the discretion to choose among alternative accounting methods.
- Investors are not thrilled when firms make accounting choices that are atypical for their industry, and lower accounting comparability relative to peers leads to lower stock market valuation of earnings.
- Low accounting comparability can be costly for both firms and managers, as it affects a firm’s equity financing capacity and managers’ equity compensation packages.
- High accounting comparability ensures benchmarking across firms, provides more relevant peer and overall industry information, and lowers investors’ firm-specific information processing costs, resulting in a more precise valuation of financial information.
- Valuation of earnings declines significantly when managers use more atypical accounting choices, representing a 25% reduction in earnings’ value relevance in firms with low accounting comparability.
- Firms with high accounting comparability see their share price rise with an EPS increase, trade at smaller bid–ask spreads, have lower stock price crash risk, and pay lower loan spreads.
- Financial statement reliability, including strong internal controls, transparency in financial reporting, and auditor industry expertise, plays a crucial role in the valuation benefits of accounting comparability.
- The interplay among accounting comparability and other financial reporting characteristics is essential, and high accounting comparability may not yield economic benefits without transparent and reliable financial reporting.
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.
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.
High accounting comparability ensures benchmarking across firms, provides more relevant peer and overall industry information, and lowers investors’ firm-specific information processing costs, resulting in a more precise valuation of financial information. Why do investors prefer comparable accounting? Facilitating benchmarking across firms, higher comparability ensures that investors can access more relevant peer and overall industry information. Lower investors’ firm-specific information processing costs and thereby facilitates a more precise valuation of financial information.
Valuation of earnings declines significantly when managers use more atypical accounting choices. For firms with low accounting comparability, the stock price goes up by $4.04 for a $1 increase in EPS, representing a 25% reduction in value relevance. On the other hand, high comparability firms can see their share price rise $6.76 with a $1 EPS increase. Analysts tend to avoid covering firms with low comparability, produce more reliable earnings forecasts for firms with high accounting comparability.
Firms with high accounting comparability trade at smaller bid–ask spreads, have lower stock price crash risk, and pay lower loan spreads. High accounting comparability may not yield economic benefits without transparent and reliable financial reporting.
Financial statement reliability, including strong internal controls, transparency in financial reporting, and auditor industry expertise, plays a crucial role in the valuation benefits of accounting comparability. Sound internal financial reporting controls are a prerequisite, and the lack of strong internal controls over financial reporting leads to investor skepticism. Even if firms have sound internal controls, accounting comparability would matter less to investors absent financial reporting transparency. Another way to build trust with investors? Hire auditors with significant industry expertise. The interplay among accounting comparability and other financial reporting characteristics is essential, and high accounting comparability may not yield economic benefits without transparent and reliable financial reporting.
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
Professional Learning for CFA Institute Members CFA Institute members are empowered to self-determine and self-report professional learning (PL) credits earned, including content on Enterprising Investor. Members can record credits easily using their online PL tracker.
“`
