Restating Financial Statements for Alternative GAAPs: Is it Worth the Effort?

Evidence suggests that share prices react rationally to changes in accounting method, “seing through” changes that have no real economic effect. Research has been less conclusive on whether share prices accurately reflect differences in accounting methods across firms. Are such differences large enough to justify analysts’ time and effort in adjusting financial statement data?

Using a sample of 96 firms randomly selected from the largest 250 industrial firms in the 1978 Fortune 500, the authors converted all firms to FIFO, converted depreciation expense and net asset values to amounts consistent with those reported for income tax purposes, consolidated wholly owned unconsolidated subsidiaries, recognized pension obligations as liabilities, and eliminated the effects of deferred tax accounting. In order to obtain a measure of the impact of restatement, they correlated net incomes and common financial ratios based on the restated figures with net incomes and ratios based on the figures as reported.

With relatively minor exceptions, the correlations between reported net incomes and financial ratios and their values restated for FIFO exceeded 99 per cent. In the case of the depreciation adjustment, correlation between reported and restated figures exceeded 98 per cent, even though 80 of the 96 firms required adjustment. Correlations between reported incomes and ratios and those restated for elimination of deferred tax amounts exceeded 97 per cent.

Consolidation of wholly owned subsidiaries had by far the largest impact on financial ratios: Despite the fact that only 23 of the 96 companies had unconsolidated subsidiaries, correlations for the quick ratio and receivables turnover were only 81 and 43 per cent, respectively. The adjustment for the prior service pension obligation also produced a low correlation—only 83 per cent for the comprehensive debt-equity ratio. Obviously, pension obligations can have a substantial effect on measures of capital structure risk.