As with many terms in financial reporting, the term comparability means different things to different people. Recently, I’ve read a number of papers that shed academic light on financial statement comparability, which means that the researchers had to define what they mean by comparability and then select an appropriate proxy for that construct.

In this blog, let me highlight just one of these papers, which is forthcoming in Journal of Accounting Research. It is written by Gus de Franco (University of Toronto), S. P. Kothari (MIT), and Rodrigo S. Verdi (MIT) and is entitled, “The Benefits of Financial Statement Comparability.” In this paper, the authors define comparability across firms by saying that, “Two firms have comparable accounting systems if, for a given set of economic events, they produce similar financial statements.” That seems reasonable enough, but the paper’s approach gets a bit more complicated when it tries to measure comparability.

Essentially, their measure of comparability is constructed in two steps. In the first step, a firm’s earnings (left side variable) is fit onto that firm’s returns (right side variable). The authors argue that the coefficient on the firm’s returns represents the accounting function that translates economic events (proxied by returns) into the financial statements (proxied by earnings). The authors then argue that firms with similar accounting functions (proxied by the coefficient on firm’s returns in the first step) should produce comparable financial statements for a given set of economic events.

In the second step, the authors argue that if their definition of comparability holds and their proxies are correct, then you can measure how comparable one firm’s financial statements are to another by calculating the negative absolute difference between firm i’s predicted earnings and firm j’s predicted earnings, using each firm’s respective accounting function (proxied by the coefficient on returns in the first step) and one of the firm’s returns for that period—essentially holding constant the economic events across the two firms. The higher this number, the smaller the differences between their predicted earnings for a given set of economic events.

I have serious questions about whether market returns are a good proxy for the economic events a firm must account for, but I’ll leave that question for future researchers to address.

Based on this approach of measuring comparability between firms, the authors come up with aggregate measures of a firm’s comparability to other firms in its industry, and they find a number of interesting empirical results. The primary results are

  • That comparability is positively related to analyst following and forecast accuracy, suggesting that the more comparable a firm’s financial statements are to other firms in its industry, the higher the number of analysts following that firm and the accuracy of those analysts.
  • That comparability is negatively related to analysts’ dispersion in earnings forecasts, suggesting that the more comparable a firm’s financial statements are to other firms in its industry, the less dispersion in earnings forecasts among analysts.

The authors conclude that, “These results suggest that financial statement comparability lowers the cost of acquiring information, and increases the overall quantity and quality of information available to analysts about the firm.” Whether you agree with their proxies in this study, the paper certainly provides a new look at comparability and is a likely benchmark against which any future papers will need to compare their own measures of comparability.

So, what do you think about this paper’s notion of comparability? Do you agree with the construct? Do you agree with how it is measured? And finally, what do standard setters learn about comparability from this paper? Are there any other recent papers out there that you know of that address the issue of comparability? I look forward to your comments and any other related research you want to highlight.