A new measure of firm-group accounting closeness

In this study we develop a new measure of firm-group accounting similarity which captures co-movement in accounting fundamentals over time. We calculate the mean of (1) the average pair-wise correlation between earnings and cash flows for a group of firms and (2) the average pair-wise R ² from regressing firm i’s earnings (cash flows) on firm j’s earnings (cash flows) within-group. We analyze how the four most widely used industrial classification schemes perform in relation to our measure. We document that the within-industry information transfer contagion effect is increasing in our measure. We confirm that within-industry similarity for the average industry varies widely and is the reason why announcement contagion effects are not observed in certain industries. Lastly, we show that the number of analysts following an industry increases in our measure of industry closeness. From an investor’s standpoint, the new measure enables them to better discern whether the performance of a group of firms is related over time. From a researcher’s standpoint, the new measure enables them to more accurately control for industry effects by capturing the fact that within-industry similarity varies across industries.