Accounting selections contain important judgment. In spite of everything, US GAAP provides companies the discretion to decide on amongst various accounting strategies in the case of stock valuation, depreciation calculation, spinoff accounting, and many others. It additionally provides managers flexibility in recognizing and measuring contingent liabilities and different transactions.
Whereas accounting chiefs might recognize having extra flexibility of their accounting selections, traders have a tendency to not be thrilled when companies make accounting decisions which might be atypical for his or her business. 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 Value Relevance of Earnings and Book Value,” the forthcoming research Bingyi Chen, Guannan Wang, and I co-authored for the Journal of Company Accounting & Finance.
The stakes are excessive: Low accounting comparability may be expensive 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 might increase a agency’s fairness financing capability in addition to its managers’ fairness compensation packages.
Why do traders choose comparable accounting? First, by facilitating benchmarking throughout companies, increased comparability ensures that traders can entry extra related peer and general business info. Second, it lowers traders’ firm-specific info processing prices and thereby facilitates a extra exact valuation of monetary info.
To check accounting comparability in investor valuation selections, we estimated a value relevance model utilizing over 31,000 observations between 1996 and 2015. On this mannequin, a agency’s inventory worth is a perform of its earnings, ebook worth of fairness, and their interplay with accounting comparability.
Our estimates present that the common agency’s inventory worth rises by $5.40 for a $1 earnings per share (EPS) improve. However the valuation of earnings declines considerably when managers use extra atypical accounting decisions. For companies with low accounting comparability, we estimate the inventory worth goes up by $4.04 for a $1 improve in EPS. This represents a 25% discount in earnings’ worth relevance.
However, following business accounting practices intently seems to repay. Not like their low comparability counterparts, excessive comparability companies can see their share worth rise $6.76 with a $1 EPS improve.
Prior research demonstrates parallel outcomes. Analysts, as an illustration, are likely to keep away from masking companies with low comparability. In spite of everything, the knowledge processing prices are increased for such companies because of the problem 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 trade at smaller bid–ask spreads, have lower stock price crash risk, and pay lower loan spreads.
Our findings spotlight an vital caveat: Traders don’t contemplate accounting comparability in a vacuum. They assess it along with monetary assertion reliability. Thus, to totally notice the valuation advantages of comparability, companies should have high-quality reporting systems and financial statements within the first place.
We examined three vital indicators of monetary assertion reliability: the presence of robust inner controls, transparency in monetary reporting, and auditor business experience.
Sound inner monetary reporting controls is a prerequisite if the worth relevance advantages of accounting comparability are to be achieved. The dearth of robust inner 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 inner management materials weak point eliminates any further worth relevance of earnings that may be obtained underneath excessive accounting comparability.
Even when companies have sound inner controls, accounting comparability would matter much less to traders absent monetary reporting transparency. Accrual accounting, by definition, has a discretionary part — for instance, allowance for uncertain receivables and estimated guarantee reserves. However, we show 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 traders have much less belief within the reported numbers, comparability turns into much less of an element of their valuation selections.
One other option to construct belief with traders? Rent auditors with important business experience. Our outcomes present that accounting comparability enhances the worth relevance of earnings extra when the agency’s auditor is a “metropolis business specialist” that additionally audits the agency’s native business friends.
Our research’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 top accounting comparability might 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 business friends and work to enhance the standard of their firms’ 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 replicate the views of CFA Institute or the writer’s employer.
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