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The Effects of Scale Differences on Inferences in Accounting Research: Coefficient Estimates, Tests of Incremental Association, and Relative Value Relevance

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  • Lo, Kin
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    Abstract

    Firms' financial data vary considerably with the size of their operations. Such scale differences potentially confound several types of inferences, of which this paper analyzes three. This paper evaluates two potential solutions to these inference problems suggested by theory: (i) deflating the data by a proxy for scale; and (ii) including a scale proxy as an independent variable. First, simulations show that deflating the data more effectively mitigates coefficient bias than including that proxy as an independent variable. Reconciling this result with the opposing conclusion of Barth and Kallapur (1996, Contemporary Accounting Research) reveals that the prior results depend on assumptions that are economically and statistically unreasonable. Second, the deflation approach results in more accurate tests of incremental association in terms of mean squared error. Third, deflating by a scale proxy results in well-specified tests of relative association using Vuong's (1989) Z-statistic for non-nested models whereas including the scale proxy as an independent variable results in overstated significance. Given the additional advantages of deflation with respect to heteroscedasticity and the coefficient of determination (R2) demonstrated in prior studies, researchers should generally deflate their models when scale differences exist in the data.

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    File URL: http://hdl.handle.net/1721.1/5420
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    Bibliographic Info

    Paper provided by Massachusetts Institute of Technology (MIT), Sloan School of Management in its series Working papers with number 555684.

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    Date of creation: 09 Jul 2004
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    Handle: RePEc:mit:sloanp:5420

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    Postal: MASSACHUSETTS INSTITUTE OF TECHNOLOGY (MIT), SLOAN SCHOOL OF MANAGEMENT, 50 MEMORIAL DRIVE CAMBRIDGE MASSACHUSETTS 02142 USA
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    Postal: MASSACHUSETTS INSTITUTE OF TECHNOLOGY (MIT), SLOAN SCHOOL OF MANAGEMENT, 50 MEMORIAL DRIVE CAMBRIDGE MASSACHUSETTS 02142 USA

    Related research

    Keywords: Econometric models; Capital markets; Financial reporting; Equity valuation;

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    Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.:
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    1. Christie, Andrew A., 1987. "On cross-sectional analysis in accounting research," Journal of Accounting and Economics, Elsevier, vol. 9(3), pages 231-258, December.
    2. Vuong, Quang H, 1989. "Likelihood Ratio Tests for Model Selection and Non-nested Hypotheses," Econometrica, Econometric Society, vol. 57(2), pages 307-33, March.
    3. Peter D. Easton & Gregory A. Sommers, 2003. "Scale and the Scale Effect in Market-based Accounting Research," Journal of Business Finance & Accounting, Wiley Blackwell, vol. 30(1-2), pages 25-56.
    4. White, Halbert, 1980. "A Heteroskedasticity-Consistent Covariance Matrix Estimator and a Direct Test for Heteroskedasticity," Econometrica, Econometric Society, vol. 48(4), pages 817-38, May.
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    Cited by:
    1. Misund, Bård & Asche, Frank & Osmundsen, Petter, 2008. "Industry upheaval and valuation: Empirical evidence from the international oil and gas industry," The International Journal of Accounting, Elsevier, vol. 43(4), pages 398-424, December.

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