Financial Statement Comparability and Idiosyncratic Return Volatility

DOIhttp://doi.org/10.1111/irfi.12227
Date01 June 2020
Published date01 June 2020
AuthorAhsan Habib,Ahmed Al‐Hadi,Mostafa Monzur Hasan
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 nancial 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 ow and performance of rms more
accurately. Therefore, we hypothesize a negative association between nan-
cial statement comparability and IRV. Using a large US sample from 1981 to
2013, we show that nancial statement comparability is associated with
lower level of IRV signicantly. We also nd this association to be more pro-
nounced in a poor information environment. This study contributes to the
emerging research that stresses the benets of nancial statement
comparability.
Accepted: 19 July 2018
I. INTRODUCTION
In this study, we examine whether the idiosyncratic return volatility (hereafter
IRV) is associated with nancial 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 ows and, hence, increases the IRV (Pástor and Vero-
nesi 2003; Rajgopal and Venkatachalam 2011; Chen et al. 2012a, 2012b).
Recent empirical evidence suggests that nancial 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 nancial 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 nancial statement
comparability improves the informational environment, and allows investors
© 2018 International Review of Finance Ltd. 2018
International Review of Finance, 20:2, 2020: pp. 383413
DOI: 10.1111/ir.12227
to better assess the quality of the rms through better comparison with peer
rms, we argue that such improvement reduces investorsuncertainty about
rmscash ows, future performance and, consequently, rm-level IRV.
Comparability describes the degree of similarity in accounting choices
among two or more rms. When common economic factors explain a large
amount of the similarity of rms in an industry, the earnings of such rms
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 rm-specic information is more useful
to these investors if they can compare similar information with other rms.
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 rm cash ow and performance, surprisingly, there is no
direct empirical evidence concerning whether nancial statement comparabil-
ity affects asset pricing and, in particular, IRV. Motivated by these research limi-
tations, we examine in this study the relation between nancial 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 nance and accounting literature. Studies relating to rm, market-wide
and economic determinants of IRV suggest a number of likely explanations for
the existence of idiosyncratic risk. These include: leverage, cash ow shocks,
option-based compensation, a higher incidence of conglomerate spin-offs, rm
life cycle, nancial 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, diversication 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
nancial statements for investment decision making (Ball and Brown 1968; Lev
1989 and many others). Financial statement comparability has been identied
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
International Review of Finance

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