Accounting selections contain vital judgment. In any case, US GAAP offers corporations the discretion to decide on amongst various accounting strategies in the case of stock valuation, depreciation calculation, spinoff accounting, and many others. It additionally offers managers flexibility in recognizing and measuring contingent liabilities and different transactions.
Whereas accounting chiefs might admire having extra flexibility of their accounting selections, traders have a tendency to not be thrilled when corporations make accounting selections which are atypical for his or her trade. Certainly, when corporations 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 research Bingyi Chen, Guannan Wang, and I co-authored for the Journal of Company Accounting & Finance.
The stakes are excessive: Low accounting comparability could be expensive for each corporations and managers. Why? As a result of they’ve financial advantages tied to that comparability. A stronger hyperlink between inventory valuation and earnings beneath 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 corporations, greater comparability ensures that traders can entry extra related peer and general trade data. Second, it lowers traders’ firm-specific data processing prices and thereby facilitates a extra exact valuation of monetary data.
To check accounting comparability in investor valuation selections, we estimated a worth relevance mannequin utilizing over 31,000 observations between 1996 and 2015. On this mannequin, a agency’s inventory worth is a operate of its earnings, e-book worth of fairness, and their interplay with accounting comparability.
Our estimates present that the typical 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 selections. For corporations 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.
Alternatively, following trade accounting practices intently seems to repay. Not like their low comparability counterparts, excessive comparability corporations can see their share worth rise $6.76 with a $1 EPS improve.
Prior analysis demonstrates parallel outcomes. Analysts, for example, are likely to keep away from masking corporations with low comparability. In any case, the data processing prices are greater for such corporations because of the issue of benchmarking and understanding their monetary statements. Furthermore, analysts have a tendency to supply extra dependable earnings forecasts for corporations with excessive versus low accounting comparability.
These aren’t accounting comparability’s solely advantages. Excessive accounting comparability corporations commerce at smaller bid–ask spreads, have decrease inventory worth crash danger, and pay decrease mortgage spreads.
Our findings spotlight an vital caveat: Buyers don’t take into account accounting comparability in a vacuum. They assess it along side monetary assertion reliability. Thus, to totally notice the valuation advantages of comparability, corporations will need to have high-quality reporting programs and monetary statements within the first place.
We examined three vital indicators of monetary assertion reliability: the presence of sturdy inner controls, transparency in monetary reporting, and auditor trade experience.
Sound inner monetary reporting controls is a prerequisite if the worth relevance advantages of accounting comparability are to be achieved. The shortage of sturdy 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 beneath excessive accounting comparability.
Even when corporations 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 reveal 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 technique to construct belief with traders? Rent auditors with vital 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 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 trade friends and work to enhance the standard of their corporations’ monetary reporting system.
If you happen to preferred this submit, don’t overlook to subscribe to the Enterprising Investor.
All posts are the opinion of the creator. As such, they shouldn’t be construed as funding recommendation, nor do the opinions expressed essentially replicate the views of CFA Institute or the creator’s employer.
Picture credit score: ©Getty Pictures / abzee
Skilled Studying for CFA Institute Members
CFA Institute members are empowered to self-determine and self-report skilled studying (PL) credit earned, together with content material on Enterprising Investor. Members can document credit simply utilizing their on-line PL tracker.