Comparability in International Accounting Standards

Prior research documents that high-quality information is positively related to ERC (Francis et al., 2007) and analysts’ responsiveness around the earnings announcements (Zhang, 2008). We identify an additional determinant of the intensity of investors’ and analysts’ reactions to earnings announcements. Privately held companies and nonprofit organizations also may be required by lenders or investors to file GAAP-compliant financial statements. For example, annual audited GAAP financial statements are a common loan covenant required by most banking institutions. Therefore, most companies and organizations in the U.S. comply with GAAP, even though it is not a legal requirement. Generally accepted accounting principles (GAAP) are uniform accounting principles for private companies and nonprofits in the U.S.

This paper is also related to the literature that evaluates the costs and benefits of uniform regimes in reporting information (Chen, Lewis, Schipper, & Zhang, 2017; Dye & Sridhar, 2008; Friedman & Heinle, 2016; Lin, Riccardi, Wang, Hopkins, & Kabureck, 2019). These studies, to some extent, are linked to the definition of comparability in this paper, although they do not directly focus on comparability. Dye and Sridhar (2008) develop a positive theory of accounting standards when standards generate network externalities and differ in flexibility. They evaluate expected value-maximizing firms’ preferences between two standards regimes, rigid and flexible. Friedman and Heinle (2016) examine the costs and benefits of uniform accounting regulation in the presence of heterogeneous firms that can lobby the regulator.

Predisclosure information, firm capitalization, and security price behavior around earnings announcements

The ultimate goal of standardized accounting principles is to allow financial statement users to view a company’s financials with certainty that the information disclosed in the report is complete, consistent, https://simple-accounting.org/comparability-principle/ and comparable. Accounting information provides useful information about business transactions and events. Those who provide and use financial reports must often select and evaluate accounting alternatives.

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. The difference between comparability and consistency is that comparability refers to the method of comparing two or more companies according to their position. On the other hand, consistency is defined as the similarity in policies and procedures of a firm, which aids the users in comparing the financial statements of a specific accounting period. You are asked to compare these competitors and determine which company is a better investment.

Accounting Principles Explained: How They Work, GAAP, IFRS

Comparability is one of the enhancing qualitative characteristics of useful financial information. Comparability allows users to compare financial position and performance across time and across companies. – Assume that company A uses the FIFO inventory method and company B uses the LIFO inventory method for valuing its inventory. All else being equal, company B’s financial statements would most likely show less income because of a higher cost of goods sold. In order to compare these statements properly, you must convert one of their inventory methods to match the other. In the United States, generally accepted accounting principles (GAAP) are regulated by the Financial Accounting Standards Board (FASB).

IFRS is a standards-based approach that is used internationally, while GAAP is a rules-based system used primarily in the U.S. IFRS is seen as a more dynamic platform that is regularly being revised in response to an ever-changing financial environment, while GAAP is more static. Therefore, accounting information is relevant if it can provide helpful information about past events and help in predicting future events or in taking action to deal with possible future events. For example, a company experiencing a strong quarter and presenting these improved results to creditors is relevant to the creditors’ decision-making process to extend or enlarge credit available to the company. You wouldn’t be able to compare two companies’ financial information with ratio analysis because their financial information wouldn’t be compatible. You could get a rough estimate on the worth of the company, but an accurate comparison wouldn’t exist.

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However, in Fang et al. (2018)’s model, there is a benevolent social planner who sets the comparability to maximize the investor’s expected payoffs. We argue that it is more reasonable to allow the firm to choose its accounting policy so that the current investors’ expected utility can be maximized. Second, Fang et al. (2018) focus on the effect of comparability on the informativeness of fundamental earnings in their paper. Our research extends this concept by further exploring the impacts of comparability on the cost of capital and investor welfare.

The less timely (thus resulting in older information), the less useful information is for decision-making. Timeliness matters for accounting information because it competes with other information. For example, if a company issues its financial statements a year after its accounting period, users of financial statements would find it difficult to determine how well the company is doing in the present. The demand for accounting information by investors, lenders, creditors, etc., creates fundamental qualitative characteristics that are desirable in accounting information. Two of the six qualitative characteristics are fundamental (must have), while the remaining four qualitative characteristics are enhancing (nice to have).

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. 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. Financial statements of one accounting period must be comparable to another in order for the users to derive meaningful conclusions about the trends in an entity’s financial performance and position over time. Comparability of financial statements over different accounting periods can be ensured by the application of similar accountancy policies over a period of time.

• This paper highlights the importance of the accounting standards quality in determining the relationship between comparability and the cost of capital.
• 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.
• Comparability is achieved when companies present information such that knowledgeable users may adjust their financial statements so as to make them comparable to other periods/companies.
• The International Financial Reporting Standards (IFRS) is the most widely used set of accounting principles, with adoption in 167 jurisdictions.
• Second, our findings that accounting comparability serves the complementary role in stock investors’ decision around the earnings announcements contribute to the growing body of research on comparability (e.g., Imhof et al., 2017, Kim et al., 2016, Sohn, 2016).

My Accounting Course  is a world-class educational resource developed by experts to simplify accounting, finance, & investment analysis topics, so students and professionals can learn and propel their careers. However, the FASB and the IASB continue to work together to issue similar regulations on certain topics as accounting issues arise. For example, in 2014, the FASB and the IASB jointly announced new revenue recognition standards. CFA Institute is the global, not-for-profit association of investment professionals that awards the CFA® and CIPM® designations. We promote the highest ethical standards and offer a range of educational opportunities online and around the world. Harold Averkamp (CPA, MBA) has worked as a university accounting instructor, accountant, and consultant for more than 25 years.

We use the short-window earnings response coefficient (ERC) as a direct measure of investors’ decision usefulness of accounting information following earnings announcements (Collins and Kothari, 1989, Francis et al., 2007, Kothari, 2001). This paper also contributes to the literature on the economic consequences (in particular, the cost of capital) of accounting standards. Some empirical studies show that the mandatory adoption of IFRS reduces the cost of capital (Daske et al., 2008, 2013; Li, 2010). In Li (2010)’s additional analyses, he finds that increased disclosure and enhanced information comparability are two mechanisms behind the cost of equity reduction after IFRS adoption in the EU. In his theoretical study, Zhang (2013) examines how the quality of accounting standards affects the cost of capital, real investment and welfare in a large economy. He shows that improving accounting standards causes an expansion of the real economy, but firms in certain risk classes end up with higher costs of capital and lower values, some of which are crowded out from the economy.

They believe because companies do not have to follow specific rules that have been set out, their reporting may provide an inaccurate picture of their financial health. In the case of rules-based methods like GAAP, complex rules https://simple-accounting.org/ can cause unnecessary complications in the preparation of financial statements. These critics claim having strict rules means that companies must spend an unfair amount of their resources to comply with industry standards.

A quality of accounting information that facilitates the comparison of financial reporting of one company to the financial reporting of another company. You wouldn’t be able to compare a company’s performance from year to year let alone two competitors’ financial statements. Without being able to compare and benchmark financial statements, the accounting information would be pretty useless.