Are Financial Statements More Comparable When GAAP Limits Managers’ Discretion?

Abstract

This study examines whether financial statements are more comparable when accounting standards limit managers’ discretion. I measure the extent to which GAAP limits managers’ discretion by counting the number of times obligatory language is used in each standard. My primary findings suggest financial statements are less comparable when GAAP limits managers’ discretion and that this effect is driven by firm-pairs that have dissimilar transactions. Further, using SFAS 141 and SFAS 86 as salient examples, I provide evidence that accounting for similar transactions using similar accounting treatments, as required by SFAS 141, is associated with more comparable financial statements, yet accounting for dissimilar transactions using similar accounting treatments, as required by SFAS 86, is associated with less comparable financial statements. Last, I examine how the impact of limiting discretion on comparability affects the cost of equity. My findings suggest that the cost of equity is higher when GAAP limits managers’ discretion and that a substantial portion of this increase is driven by the decline in comparability associated with limiting managers’ discretion.