Financial Reporting Quality and Peer Group Composition

Abstract

Similarity between a firm and a potential peer firm with respect to important economic characteristics is a first-order criterion to select peer firms. As economic characteristics are often captured through information disclosed in publicly available financial reports, financial reporting quality (FRQ) of a potential peer firm could influence the peer group selection. We hypothesize that potential peer firms with higher FRQ are more likely to be included in the peer group of another firm because the reduced information asymmetry and lower reputation costs connected to higher FRQ of potential peer firms can influence the board of directors’ judgment of similarity between the firm and a potential peer firm. Analyzing the peer groups used by S&P 900 firms for benchmarking executive compensation packages, we find support for our hypothesis and the channels we specify in our theory. Our results are robust across several measures for FRQ, albeit they are somewhat weaker when FRQ is measured by means of internal control deficiencies, fraud, and AAERs. Using alternative specifications to define the potential peer group does not change our inferences and our results also hold when we control for the presence of the potential peer firm in the peer group of the previous year. This study contributes to previous research on peer groups by examining the accounting information environment around peer group composition.

Keywords: financial reporting quality, peer groups, information asymmetry, reputation cost

JEL Classification: G34, M40, M52