By comparing the financial information, you can see that Company B has higher revenue and gross profit than Company A. Both companies have the same gross profit margin, which indicates they have similar efficiency in generating profit from their sales. This comparison helps you make an informed investment decision based on the financial performance of the companies. 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.
The comparability concept of accounting states that the users of financial reports of a business must be able to compare these reports with previous years’ reports as well as with reports of other entities dealing in the same industry. – US GAAP and the International Standards or IFRS have many standards in common, but they also disagree on many common accounting practices. For instance, US GAAP allows for a different method of accounting for pension programs. This means that a US based company like GM won’t use the same accounting methods as a foreign-based company like Toyota.
A change in the accounting policies of an entity may be required in order to improve the reliability and relevance of financial statements. A change in the accounting policy may also be imposed by changes in accountancy standards. In these circumstances, the nature and circumstances leading to the change must be disclosed in the financial statements. It does not require all companies to adopt the same accounting policies because doing so would impair relevance. 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.
These standards are designed to promote consistency, transparency, and accuracy in financial reporting, reducing the risk of misinterpretation or manipulation of financial information. However, it is important to note that some differences may still arise due to varying accounting methods, estimates, and judgments, as well as the inherent complexity of certain business transactions and financial instruments. Our study’s key takeaway is that there is an interplay among accounting comparability and other financial reporting characteristics. Financial statement preparers and other stakeholders should know that high accounting comparability may not yield economic benefits without transparent and reliable financial reporting. So accounting chiefs should pay close attention to the accounting policies of their industry peers and work to improve the quality of their companies’ financial reporting system.
What are the Qualitative Characteristics of Accounting Information?
It also gives managers flexibility in recognizing and measuring contingent liabilities and other transactions. In today’s society, corporate annual reports are in excess of 100 pages, with significant qualitative information. Information that is understandable to the average user of financial statements is highly desirable.
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. Comparability is the level of standardization of accounting information that allows the financial statements of multiple organizations to be compared to each other. This is a fundamental requirement of financial reporting that is needed by the users of financial statements. High accounting comparability firms trade at smaller bid–ask spreads, have lower stock price crash risk, and pay lower loan spreads.
Changes to accounting policy must be accounted for prospectively, i.e. resulting change should not have impact on prior period financial statement comparatives. Consistency refers to application of accounting standards and policies consistently from one period to another and from one region to another. After all, US GAAP gives firms the discretion to choose among alternative accounting methods when it comes to inventory valuation, depreciation calculation, derivative accounting, etc.
- Our study’s key takeaway is that there is an interplay among accounting comparability and other financial reporting characteristics.
- Information that is understandable to the average user of financial statements is highly desirable.
- All else being equal, company B’s financial statements would most likely show less income because of a higher cost of goods sold.
- For instance, US GAAP allows for a different method of accounting for pension programs.
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. While accounting chiefs may appreciate having more flexibility in their accounting decisions, investors tend not to be thrilled when firms make accounting choices that are atypical for their industry. Indeed, when firms exhibit lower accounting comparability relative to their peers, the stock market values their earnings at a lower rate. That’s among the conclusions of “Accounting Comparability and the Value Relevance of Earnings and Book Value,” the forthcoming study Bingyi Chen, Guannan Wang, and I co-authored for the Journal of Corporate Accounting & Finance.
Don’t Overlook Accounting Comparability
A switch from FIFO to LIFO basis of inventory valuation may cause a shift in the value of inventory between the accounting periods largely due to seasonal fluctuations in price. Financial statements of one entity must also be consistent with other entities within the same line of business. This should aid users in analyzing the performance and position of one company relative to the industry standards. It is therefore necessary for entities to adopt accounting policies that best reflect the existing industry practice. Changes to accounting policy must be accounted for retrospectively, i.e. amounts recognized in previous accounting periods are restated to account for the change in accounting policy.
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). Comparability is extremely important to the end users of financial statements. If financial statements can’t be compared with other statements, what good are they?
His research has been published in such journals as the Journal of Accounting and Economics and European Accounting Review and cited in various media outlets, including the Wall Street Journal, Bloomberg, and CFO.com. The presentation of liabilities is different in both years, which is not appropriate as it does not ensure comparability of financial reports/statements. Verifiability is the extent to which information is reproducible given the same data and assumptions.