Financial Statement Comparability and Idiosyncratic Return Volatility

• Author: Ahsan Habib,Ahmed Al‐Hadi,Mostafa Monzur Hasan
• DOI: http://doi.org/10.1111/irfi.12227
• Published date: 01 June 2020
• Date: 01 June 2020

Financial Statement Comparability

and Idiosyncratic Return Volatility

AHSAN HABIB

†

,MOSTAFA MONZUR HASAN

‡

AND AHMED AL-HADI

§

†

School of Accountancy, Massey University, Auckland, New Zealand

‡

School of Economics and Finance, Curtin University, Perth, Australia and

§

School of Accounting, Curtin Business School, Curtin University, Perth, Australia

ABSTRACT

This study examines the association between financial statement comparabil-

ity and idiosyncratic return volatility (IRV). A greater degree of comparability

lowers information acquisition costs, reduces the uncertainties associated

with performance evaluation, and increases the overall quantity and quality

of information available to corporate outsiders, which, in turn, helps inves-

tors to understand and evaluate the cash flow and performance of firms more

accurately. Therefore, we hypothesize a negative association between finan-

cial statement comparability and IRV. Using a large US sample from 1981 to

2013, we show that financial statement comparability is associated with

lower level of IRV significantly. We also find this association to be more pro-

nounced in a poor information environment. This study contributes to the

emerging research that stresses the benefits of financial statement

comparability.

Accepted: 19 July 2018

I. INTRODUCTION

In this study, we examine whether the idiosyncratic return volatility (hereafter

IRV) is associated with financial statement comparability. Also, we investigate

the possible settings under which this association, if any, may vary cross-sec-

tionally. Prior studies have documented that information asymmetry arising

from a poor information environment increases heterogeneity in investors’

beliefs about future cash flows and, hence, increases the IRV (Pástor and Vero-

nesi 2003; Rajgopal and Venkatachalam 2011; Chen et al. 2012a, 2012b).

Recent empirical evidence suggests that financial statement comparability

improves the information environment, as evidenced by an increase in analyst

following, a reduction in forecast error, and forecast dispersion (De Franco

et al. 2011). Comparability also improves financial reporting quality, discour-

ages managerial incentives for bad news hoarding, and lowers information

asymmetry, as proxied by the bid-ask spread and illiquidity (De Franco

et al. 2011; Peterson et al. 2015; Kim et al. 2016). Since financial statement

comparability improves the informational environment, and allows investors

© 2018 International Review of Finance Ltd. 2018

International Review of Finance, 20:2, 2020: pp. 383–413

DOI: 10.1111/irfi.12227

to better assess the quality of the firms through better comparison with peer

firms, we argue that such improvement reduces investors’uncertainty about

firms’cash flows, future performance and, consequently, firm-level IRV.

Comparability describes the degree of similarity in accounting choices

among two or more firms. When common economic factors explain a large

amount of the similarity of firms in an industry, the earnings of such firms

should be readily comparable. The Financial Accounting Standards Board

(FASB), in its conceptual framework, indicates that comparability enriches the

usefulness of information for making decisions. In particular, Concept State-

ment # 8 of the FASB (2010) notes that firm-specific information is more useful

to these investors if they can compare similar information with other firms.

This is particularly pertinent to the equity market, where an investment deci-

sion essentially entails evaluations of alternative opportunities or projects, and

these decisions cannot be made without comparable information. Despite the

anecdotal evidence that comparability makes it easier for investors to under-

stand and evaluate firm cash flow and performance, surprisingly, there is no

direct empirical evidence concerning whether financial statement comparabil-

ity affects asset pricing and, in particular, IRV. Motivated by these research limi-

tations, we examine in this study the relation between financial statement

comparability and IRV.

Extant studies have shown that IRV constitutes the largest component of risk

in an individual stock (e.g., Goyal and Santa-Clara 2003; Morck et al. 2013).

Therefore, the determinants of IRV have received considerable research interest

in the finance and accounting literature. Studies relating to firm, market-wide

and economic determinants of IRV suggest a number of likely explanations for

the existence of idiosyncratic risk. These include: leverage, cash flow shocks,

option-based compensation, a higher incidence of conglomerate spin-offs, firm

life cycle, financial reporting quality, and social capital (e.g., Campbell

et al. 2001; Ang et al. 2006; Wei and Zhang 2006; Irvine and Pontiff 2009; Raj-

gopal and Venkatachalam 2011; Hasan and Habib 2017a, 2017b). Examining

the relationship between comparability and IRV is especially critical as IRV has

important implications for portfolio management, diversification strategy, arbi-

trage process, valuation of employee stock options and managerial compensa-

tion policies (March and Shapira 1987; Weber 2004).

Theoretical underpinnings on the association between comparability and

IRV are premised on well-established literature indicating that investors rely on

financial statements for investment decision making (Ball and Brown 1968; Lev

1989 and many others). Financial statement comparability has been identified

as one of the most important characteristics of accounting information

intended to assist investors in making informed decisions (FASB 2010). A higher

degree of accounting comparability lowers the cost of information acquisition,

reduces the uncertainties associated with performance evaluation when similar

economic transactions are reported differently, and increases the overall quan-

tity and quality of information available to corporate outsiders (DeFond

et al. 2011; Barth et al. 2012; Kim et al. 2013; Chen et al. 2018). These positive

© 2018 International Review of Finance Ltd. 2018384

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