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Comparability and Cost of Capital
I. Introduction
We investigate the information benefits of financial statement comparability by
examining its effect on firm cost of capital. Hail, Leuz and Wysocki (2011) suggest that one
benefit of greater comparability is a lower cost of capital. However the relation between
comparability and a company’s cost of capital has not been investigated empirically in the
accounting research.
In the FASB’s Concept Statement No. 2 Qualitative Characteristic of Accounting
Information, comparability is defined as “the quality of information that enables users to identify
similarities in and differences between two sets of economic phenomena.... Information about a
particular enterprise gains greatly in usefulness if it can be compared with similar information
about other enterprises (FASB 1980, Con. 2 pp. 4-20).” One implication of this view of
comparability is that more comparable information has greater usefulness for decision making. .
Dechow, Ge and Strand (2010) indicate that information can be said to be decision relevant only
in the context of a specific decision model. Understanding the relation between financial
statement comparability and cost of capital helps regulators and managers understand how more
comparable information is useful for investor decision-making.
We use the comparability measure proposed by De Franco, Kothari, and Verdi (2011)
that considers the accounting system to be a “mapping” of information from economic events
into financial statements. Where stock returns proxy for the effects of economic events on a
firm’s financial statements, comparability increases as the similarity between the “mapping” of
economic events (stock returns) into financial statements (earnings) for two firms increases. This
approach captures comparability from the perspective of financial information users and
contrasts with input-based definitions where companies are viewed to provide comparable '

financial information because they are using similar accounting methods and principles (DeFond,
Hu, Hung and Li, 2011).‘
De Franco et al. (2011) supply a clarifying example from Stickney and Weil (2006, p.
189) that provides insight into the decision usefulness attributes of comparability that may affect
a company’s cost of capital. It states that “ratios, by themselves out of context, provide little
information” and so it is important to have something to compare to when using ratios to gain
insight into a firm’s worth. This example implies that comparability does not necessarily provide
more information but rather provides investors with a context to better use available information
for making economic decisions.
Our study is important for several reasons. First comparability is an important concept in
the FASB and the IASB conceptual frameworks, but how comparability is related to a firm’ cost
of capital remains an open question. Past studies emphasize this link when outlining the
potential benefits from global convergence of accounting standards (e.g., Hail and Leuz and
Wysocki 2011, p. 387). They argue that greater comparability can increase market liquidity and
reduce firms’ costs of capital, but provide no empirical evidence to support this argument.2
Second, even though De Franco et al. (2011) suggest their comparability measure
provides insight into improved decision usefulness of accounting data, they do not speculate
about how their measure relates to a company’s cost of capital. They do, however, maintain that
“information about comparable firms lowers the cost of acquiring information and increases the
overall quantity and quality of infom1ation available about the firm” (De Franco et al., 2011: p.
897). This conclusion appears to be consistent with those found in past research investigating
_ how information characteristics are associated with a lower cost of capital but suggests that there
may be something more captured by comparability that is not captured by measures of
information asymmetry.
Third, Lambert et al. (2011) predict, and Armstrong et al. (2011) provide empirical
evidence suggesting, that market perfection affects investors’ abilities to gather and use
information. We extend this research to investigate how market perfection/imperfection impacts
the relation between comparability and cost of capital and altematively, how comparability
impacts the relation between information asymmetry and cost of capital, conditioned on market
perfection/imperfection. These tests allow us to both isolate potential conditions under which
comparability is linked to a firm’s cost of capital and to gage whether comparability diminishes
information risk in determining a firm’s cost of capital.
Our research design consists of three steps. First we investigate the unrestricted case of
the relation between the De Franco et al. (2011) comparability measure and a firm’s cost of
capital. This step is consistent with Hail, Leuz and Wysocki (2011) that suggests greater
comparability is associated with a lower cost of capital. Consistent with past research, we expect
an inverse relation between comparability and cost of capital. In the second step we sort our
sample based on the level of competition for a firm’s shares (a proxy for market perfection) and
focus on companies whose shares trade in highly imperfect markets. This is the environment that
Lambert et al. (2012) and Armstrong et al. (2011) have shown to be consistent with the pricing
of information asymmetry in the cost of capital because investors would otherwise be able to rely
on information contained in security prices (Kyle et al l985).3 If the benefits of comparability are
also dependent on market perfection/imperfection environment, we expect the inverse
relationship between the De Franco comparability measure and cost of capital to be stronger
when equity markets are imperfect. In the third step we sort observations into subsamples based
on equity market imperfection and examine whether comparability impacts the relation between
information asymmetry and cost of capital. This last step is consistent with guidance found in
past research (Armstrong et al. 2011 and Lambert, Leuz, and Verrecchia 2011) and allows us to
investigate whether comparability affects the impact of information asymmetry on a firm’s cost
‘of capital. _
Our results are consistent with our expectations and imply that comparability’s effects on
cost of capital are affected by the perfection\imperfection of the trading environment and are
incremental to the effect of information asymmetry. Results from our first step indicate
comparability is inversely associated with cost of capital, suggesting it reduces investor
information ‘risk. Results from our second step suggest the inverse relation between
comparability and cost of capital is increasing in market imperfection. We find the negative
relation between comparability and cost of capital is strongest for firms with a low number of
shareholders (a measure of market imperfection). This result is robust to an altemative measure
of market perfection (low trading activity) and is economically as well as statistically significant.
Results from our third step suggest comparability is incremental to the impact of information
asymmetry on firm cost of capital. For firms characterized by high information asymmetry and
low public trading, financial statement comparability at least partially reduces estimation risk to
investors, leading to lower required rates of retum. This result is economically significant as
3 Perfect competition refers to the scenario where demand curves are flat, and assumes that the number of trades in a
firm’s shares is infinite (Hellwig, 1980; Shleifer, 1986).

 

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