Academic journal article Academy of Accounting and Financial Studies Journal

Are NAICS Industries More Homogeneous Than SICS Industries?

Academic journal article Academy of Accounting and Financial Studies Journal

Are NAICS Industries More Homogeneous Than SICS Industries?

Article excerpt

INTRODUCTION

Industry groupings of companies have many applications in business. It is common to compare a firm's financial performance to an industry peer group. For instance, bankers often evaluate commercial loans by comparing applicant firms' financial statements to industry measures (http://www.eciequity.com/rma_industry_comparisons.htm). Also, such benchmarking services as the Aberdeen Group (http://www.aberdeen.com/) and Enovation (http://www.enovation.com.au/) offer to evaluate how clients' performances measure up to their industry peers. Not only are companies interested in comparing themselves to similar companies, but their auditors also compare such client performance indicators as ratios to industry standards to help evaluate risk (e.g., Winograd, Gerson & Berlin, 2000). This extensive use of industry comparisons in practice is supported by research that concludes that financial statement comparisons are meaningful when made among like members of groups, such as industries (Lee, 1985). As a result, this study uses financial statement information to identify homogenous groupings of firms.

Two well-known industry classification schemes are the Standard Industry Classification System (SICS) and the North American Industry Classification System (NAICS). Morgan Stanley and Standard & Poor's have also developed a third scheme, the Global Industry Classification Standards. However, because many accounting firms' analyses are now based on NAICS industries instead of their prior SICS-based analyses, we restrict our study to comparing NAICS and SICS. The question asked in this study is: does financial statement information suggest that NAICS groups are always more homogenous than SICS groups of firms?

SICS is a self-classification system that has been in use since the 1933 and 1934 SEC Acts. Although revisions have been made to the SICS classifications throughout the years, the original product/output orientation has remained, but has fostered the criticism that it does not reflect the changes to processes that characterize our economy (Fama & French, 1997; Krishnan & Press, 2002; Bhojraj, Lee & Oler, 2003).

NAICS is the second major classification scheme. In 1994, the Office of Management and Budget issued a notice of intent to change from SICS to NAICS as an official classification method (OMB, 1994) and the framework was released in 1996 (see http://www.census.gov/epcd/www/naicsdoc.htm). The NAICS categories are based on production processes, rather than product outputs. For example, tire retreading and repair shops are classified under services using SICS codes (7534), but are classified with manufacturing of rubber products using NAICS codes (326212). Firms that use different processes are classified under different NAICS codes, even though they produce the same product. For instance, SIC 3131 includes firms that manufacture boot soles and heels, but NAICS classifications differentiate between metal (339993) and wood (321999) heel manufacturers.

Because of the difference in the conceptual bases of SICS and NAICS, their application results in different firms being grouped together. Thus, if a firm's financial performance is compared to the performance of other members of that firm's industry, different comparisons could result, depending on which classification scheme is used. Accordingly, like Lee (1985) and Ezzamel, Mar-Molinero & Beecher (1987), we believe that firms' homogeneity will be evident in their financial statement similarities so we use accounting variables to measure industry-member homogeneity. The variables used are (1) change in operating expenses, (2) change in sales, and (3) accounting policies. The evidence presented in this paper suggests that types of NAICS classifications may offer improved financial statement homogeneity for some industry group members.

The next section motivates the research and develops the hypotheses. …

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