Internal capital market efficiency and the diversification discount: The role of financial statement comparability

• Author: Ruei‐Shian Wu,Jia‐Chi Cheng
• Published date: 01 May 2018
• DOI: http://doi.org/10.1111/jbfa.12307
• Date: 01 May 2018

DOI: 10.1111/jbfa.12307

Internal capital market efficiency and the

diversification discount: The role of financial

statement comparability

Jia-Chi Cheng Ruei-Shian Wu

AccountingDiscipline, College of Management,

YuanZe University, Taiwan,135 Yuan-TungRoad,

Chung-Li,Taoyuan 32003, Taiwan

Correspondence

Ruei-ShianWu, Accounting Discipline, College

ofManagement, Yuan Ze University,Taiwan,

135Yuan-TungRoad, Chung-Li, Taoyuan32003,

Taiwan.

Email:rswu@saturn.yzu.edu.tw

JELClassification: G14, G32, M41

Abstract

This paper investigates how financial statement comparability

affects the efficiency of internal capital markets and diversifica-

tion discounts in multi-segment firms through monitoring mecha-

nisms. Previous studies suggest that financial statement compara-

bility improves transparency and reduces the cost of information

processing, mitigating information asymmetry between managers

and shareholders. Using measures of comparability and internal cap-

ital efficiency, we find that financial statement comparability has a

strong positive influence on internal capital market efficiency. Fur-

ther, we find that by improving the efficiency of internal capital

markets, financial statement comparabilityindeed mitigates diversi-

fication discounts. Especially, the effect of financial statement com-

parability is more pronounced for firms with high information asym-

metry or operating environment volatility. The results support our

arguments that financial statement comparability enhances the effi-

ciency of internal capital markets and increases firm value in diversi-

fied firms by mitigating agency problems via monitoring and corpo-

rate control mechanisms.

KEYWORDS

capital allocation, corporate governance, diversification discount,

financial statement comparability,internal capital market

1INTRODUCTION

This paper investigates whether financial statement comparability improves the internal capital market efficiency of

diversified firms and mitigates diversification discounts through the monitoring mechanism. Diversified firms can be

more efficient and value-added than focused firms because internal capital markets of diversified firms allow them to

allocate resources better than external marketsand reduce the need for costly external financing. However, an essen-

tial issue in the efficiency of internal capital marketsis that delegated managers of diversified firms do not always make

decisions in the shareholders’ best interest when information asymmetry is high and there is a lack of external moni-

toring. Therefore, it could be important for diversified firms to use high-quality accounting standards with comparable

financial statements to facilitate the efficiency of internal capital markets and enhance firm value.

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CHENG ANDWU 573

Research finds that moral hazard and adverse selection affect the efficiency of capital allocation because infor-

mation asymmetry exists between managers and external investors. Financial statement comparability reduces this

information asymmetry because it providesa deeper understanding of firm performance, thus improving oversight and

monitoring of managers’ investment decisions. Furthermore,empirical evidence demonstrates that when target firms’

financial statements exhibitgreater comparability with peer firms, acquirers make better acquisition decisions, foster-

ing more efficient capital allocation (Chen, Collins, Kravet, & Mergenthaler,2014). Likewise, comparability increases

the informativeness of stock prices by incorporating information about future earnings (Choi, Choi, Myers,& Ziebart,

2014), and attracting analyst coverageand improving analyst forecast accuracy (De Franco, Kothari, & Verdi,2011).

DeFond, Hu, Hung, and Li (2011) investigatethe capital market consequences of International Financial Reporting

Standards (IFRS) adoption through the lens of comparability and find foreign mutual fund ownership increases with

comparability in 14 EU countries. Accordingly, financial statement comparabilityis important in evaluating investing

and financing opportunities and results in capital-allocation efficiency.

Managers generally allocate internal capital to segments with superior profits. However,it is well documented that

on average,diversified firms are less valuable than focused firms (Berger & Ofek, 1995; Lamont, 1997; Lamont & Polk,

2002; Lang & Stulz, 1994; Servaes, 1996; Shin & Stulz, 1998). The literature on agency problems argues that the value

difference between diversified firms and focused firms represents agency costs stemming from information asymme-

try and misallocation of internal capital. Financial statement comparability mitigates these problems. As a result, this

paper predicts that financial statement comparability has a strong positive influence on internal capital market effi-

ciency and may mitigate the negative impact of diversification due to information asymmetry and agency problems.

Furthermore,we expect the effect of comparability on corporate investment efficiency and value to differ across firms.

Todemonstrate our argument, this paper further investigateswhether comparability results in higher benefits for firms

facing more severe information asymmetry problems.

Following the internal capital market literature, we use relative value added by allocation (RVA) from Rajan,

Servaes, and Zingales (2000) to capture the efficiency of capital allocation. For firm value in diversification decisions,

we adopt the industry-multiplier approach developed by Berger and Ofek (1995) to estimate the excess value of

diversified firms. We also use two aggregated, firm-level variables (CompAcct4 and CompAcctInd) developed by De

Francoet al. (2011) to measure financial statement comparability. Our sample consists of 20,932 diversified firm-year

observations in the US from 1980 to 2014, after excluding missing observations and extreme outliers. However, the

agency problem explanation in the literature on diversification is compelling though not conclusive evidence of the

cause of inefficient internal capital marketsand diversification discounts. Because firms choose to diversify, the results

may cause endogeneity in diversification decisions (e.g.,Campa & Kedia, 2002; Graham, Lemmon, & Wolf, 2002). Thus,

to corroborate our empirical results and our arguments, we control for the endogeneity problem. Furthermore,we use

alternative comparability measures and consider the extent of information asymmetry and operating environment

volatility in our regression models.

Our first argument is that financial statement comparability can facilitate monitoring of corporate control mech-

anisms and prevent managers from misallocating internal capital. The empirical results support our conjecture that

firms with more comparable financial statements havemore efficient internal capital markets.

Our second argument is that financial statement comparability, as a form of corporategovernance, is worth more

because it mitigates the decline in excess value from diversification. Our empirical results also support our hypoth-

esis by demonstrating that firms with more comparability have lower diversification discounts. Further, the empir-

ical results suggest that financial statement comparability can provide better benefits for firms facing more severe

agency problems. In conclusion, financial statement comparability can alleviate agency problems for multi-segment

firms, which is the root of internal capital inefficiency (Holod, 2012), and further reduces subsequent value destruction

(Berger & Ofek, 1995; Lang & Stulz, 1994).

This paper makesseveral contributions to the literature on financial statement comparability. First, we obtain clear-

cut implications on the benefits of financial statement comparabilityfor internal capital markets. Prior studies focusing

on firm performance and external capital allocation explore how comparability benefits firms’ information environ-

ments, and thereby increases the market liquidity and market efficiency.Most of these studies shed light on certain

574 CHENG ANDWU

benefits of comparability, such as more transparent reporting, more accurate analyst forecasts, and lower costs of

debt capital (e.g., Chen et al., 2014; De Franco et al., 2011; Kim, Kraft, & Ryan, 2013). However, a gap remains in our

understanding of how financial statement comparability enhances governance benefits. Furthermore, the literature

does not yet clearly address how comparability helps governancemechanisms enhance the efficiency of internal capi-

tal markets, which is essential for diversifiedfirms and firm value. This study fills that gap by providing direct evidence

of how financial statement comparability affects the efficiency of internal capital marketsand firm value in conglomer-

ates with agency problems.

Second, this paper contributes to the literature on diversification and firm value. Existing studies offer abundant

yet inconclusive evidence on the causes of the diversification discount for multi-segment firms. These inconsistent

findings may be the result of agency problems (Berger & Ofek, 1995; Hoechle, Schmid, Walter, & Yermack, 2012;

Servaes, 1996), endogeneity problems (Campa & Kedia, 2002; Villalonga, 2004), biases in segment data (Villalonga,

2004), or the presence of moderating factors in the diversification-value relationship (Rajan et al., 2000). This

paper provides one compelling (though not conclusive) explanation for the causes of diversification discounts for

multi-segment firms. Our findings provide evidence that through corporate control, financial statement compara-

bility alleviates information asymmetry between management and shareholders and thus enhances internal capital

market efficiency and firm value in diversification. Such improvement in the use of internal capital facilitates the

first best equilibrium in corporate investment decisions and lessens the diversification discount for multi-segment

firms.

Finally,we identify certain limitations in our research that offer fertile ground for future study. First, our work uses

US diversified firms to understand the influence of financial statement comparability and its corporate governance

role in internal capital marketswith agency problems in the US economy. It might prove interesting to conduct a similar

analysis in an international setting. Second, this study does not address the costs of financial statement comparabil-

ity. The cost of IFRS compliance includes preparation and certification costs, audit costs, and other transition costs,

which are significant because of the greater effort, knowledge, and information systems needed to implement the new

standards. The trade-off between benefits and costs and the relation between comparabilityand net wealth are worth

further examination, which is beyondthe scope of this study.

The remainder of the paper is divided into five sections. The theoretical background and hypothesis development

are presented in section 2. The details of research design appear in section 3. Section 4 describes sample selection

and descriptive statistics. Section 5 contains the empirical results for multivariable regression models and robustness

checks. Section 6 concludes.

2THEORETICAL BACKGROUND AND HYPOTHESIS DEVELOPMENT

2.1 The information role of comparability and capital market efficiency

A common financial language, applied consistently, enables investors to easily compare financial results among com-

panies, reduces the cost of capital, and provides more investment opportunities with better returns. Comparability is

the qualitative characteristicof financial information that enables users to identify and understand similarities and dif-

ferences among firms (FASB and IASB, 2010). The fundamental notion of comparability in financial reporting is that

accounting amounts are analogous when two firms face similar economic events. Economic decisions that compare

alternatives and financial results cannot be evaluated in isolation. The difficulty is in making meaningful comparisons

without comparable benchmarks. Financial statement comparabilityenhances investors’ ability to understand the link

between accounting numbers and economic outcomes and to compare firms’ performance.

According to proponents of IFRS, publicly traded companies must applya single set of high-quality accounting stan-

dards in order to make capital marketsmore efficient. Also, IAS Regulation (Regulation No. 1606/2002) and the Secu-

rities and Exchange Commission (SEC) suggest that comparabilityof investments facilitates efficient capital allocation

and enhances investor confidence.