Accounting selections contain important judgment. In any case, US GAAP provides companies the discretion to decide on amongst different accounting strategies in the case of stock valuation, depreciation calculation, spinoff accounting, and so on. It additionally provides managers flexibility in recognizing and measuring contingent liabilities and different transactions.

Whereas accounting chiefs could admire having extra flexibility of their accounting selections, buyers have a tendency to not be thrilled when companies make accounting selections which can be atypical for his or her trade. Certainly, when companies exhibit decrease accounting comparability relative to their friends, the inventory market values their earnings at a decrease price. That’s among the many conclusions of “Accounting Comparability and the Worth Relevance of Earnings and Guide Worth,” the forthcoming examine Bingyi Chen, Guannan Wang, and I co-authored for the Journal of Company Accounting & Finance.

The stakes are excessive: Low accounting comparability might be pricey for each companies and managers. Why? As a result of they’ve financial advantages tied to that comparability. A stronger hyperlink between inventory valuation and earnings underneath excessive comparability could increase a agency’s fairness financing capability in addition to its managers’ fairness compensation packages. 

Why do buyers choose comparable accounting? First, by facilitating benchmarking throughout companies, increased comparability ensures that buyers can entry extra related peer and general trade info. Second, it lowers buyers’ firm-specific info processing prices and thereby facilitates a extra exact valuation of economic info.

To check accounting comparability in investor valuation selections, we estimated a price relevance mannequin utilizing over 31,000 observations between 1996 and 2015. On this mannequin, a agency’s inventory value is a operate of its earnings, guide worth of fairness, and their interplay with accounting comparability.

Our estimates present that the typical agency’s inventory value rises by $5.40 for a $1 earnings per share (EPS) enhance. However the valuation of earnings declines considerably when managers use extra atypical accounting selections. For companies with low accounting comparability, we estimate the inventory value goes up by $4.04 for a $1 enhance in EPS. This represents a 25% discount in earnings’ worth relevance.

Alternatively, following trade accounting practices intently seems to repay. Not like their low comparability counterparts, excessive comparability companies can see their share value rise $6.76 with a $1 EPS enhance.

Prior analysis demonstrates parallel outcomes. Analysts, for example, are likely to keep away from protecting companies with low comparability. In any case, the knowledge processing prices are increased for such companies as a result of issue of benchmarking and understanding their monetary statements. Furthermore, analysts have a tendency to supply extra dependable earnings forecasts for companies with excessive versus low accounting comparability.

These aren’t accounting comparability’s solely advantages. Excessive accounting comparability companies commerce at smaller bid–ask spreads, have decrease inventory value crash danger, and pay decrease mortgage spreads.

Our findings spotlight an essential caveat: Traders don’t contemplate accounting comparability in a vacuum. They assess it at the side of monetary assertion reliability. Thus, to completely understand the valuation advantages of comparability, companies will need to have high-quality reporting programs and monetary statements within the first place.

We examined three essential indicators of economic assertion reliability: the presence of sturdy inside controls, transparency in monetary reporting, and auditor trade experience.  

Sound inside monetary reporting controls is a prerequisite if the worth relevance advantages of accounting comparability are to be achieved. The shortage of sturdy inside controls over monetary reporting results in investor skepticism and questions on whether or not disclosed accounting insurance policies are utilized correctly. Notably, we discover that reporting an inside management materials weak spot eliminates any extra worth relevance of earnings that may be obtained underneath excessive accounting comparability.

Even when companies have sound inside controls, accounting comparability would matter much less to buyers absent monetary reporting transparency. Accrual accounting, by definition, has a discretionary part — for instance, allowance for uncertain receivables and estimated guarantee reserves. However, we exhibit that reporting persistently excessive ranges of discretionary accruals compromises a agency’s monetary reporting transparency and thereby reduces the advantages of accounting comparability. That’s, if buyers have much less belief within the reported numbers, comparability turns into much less of an element of their valuation selections.

One other strategy to construct belief with buyers? Rent auditors with important trade experience. Our outcomes present that accounting comparability enhances the worth relevance of earnings extra when the agency’s auditor is a “metropolis trade specialist” that additionally audits the agency’s native trade friends.

Our examine’s key takeaway is that there’s an interaction amongst accounting comparability and different monetary reporting traits. Monetary assertion preparers and different stakeholders ought to know that prime accounting comparability could not yield financial advantages with out clear and dependable monetary reporting. So accounting chiefs ought to pay shut consideration to the accounting insurance policies of their trade friends and work to enhance the standard of their corporations’ monetary reporting system.

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All posts are the opinion of the writer. As such, they shouldn’t be construed as funding recommendation, nor do the opinions expressed essentially mirror the views of CFA Institute or the writer’s employer.

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Ahmet C. Kurt, PhD

Ahmet C. Kurt is an assistant professor of accounting at Bentley College. He holds a PhD diploma from the College of Pittsburgh and an MBA diploma from the College of Alabama. His analysis has been printed in such journals because the Journal of Accounting and Economics and European Accounting Assessment and cited in numerous media shops, together with the Wall Avenue Journal, Bloomberg, and CFO.com.