The book-to-market ratio (`BM`

) is one of the most frequently calculated variables in accounting research and is usually used as a control variable in regressions. However, how to calculate it is a question I often asked when I started my PhD, as nobody defined it clearly in their papers. Should I use `CEQ`

or `SEQ`

, assets minus liabilities, or something else? This question becomes even more confusing when I realize that finance researchers often define the book value of equity differently from accounting researchers.

A related question is how to verify the basic accounting equation (A = L + E) using Compustat Annual (FUNDA) or Quarterly (FUNDQ) data? To answer this question, I checked the Compustat Manuals – Balancing Models – North American Company Data:

Therefore, the basic accounting equation is reflected in the following relationship:

`AT`

= `LSE`

Or `AT`

= `LT`

+ `MIB`

+ `TEQ`

The first equation can be verified using FUNDA data. However, the second equation holds true for only 42% of observations. Further investigation indicates that prior to FASB 160, `LSE`

= `LT`

+ `MIB`

+ `SEQ`

, while after FASB 160, `LSE`

= `LT`

+ `MIB`

+ `TEQ`

. That’s why the above second equation won’t hold true prior to FASB 160.

Returning to the initial question, `BM`

= Book Value of Equity (`BVE`

) / Market Value of Equity (`MVE`

). When calculating `MVE`

, we appear only able to use `MVE`

= `csho`

× `prcc_f`

, where `csho`

is the number of common shares outstanding, and `prcc_f`

is the share price at the fiscal year-end. Therefore, `MV`

will be the market value of common shares. To match this, it seems appropriate to define `BVE`

as `ceq`

(also common shares), and thus `BM`

= `ceq`

/ (`csho`

× `prcc_f`

).

In contrast, in the sample code provided by WRDS to replicate Fama-Frech’s three factors, as well as in the Financial Ratios macro provided by WRDS, `BVE`

= `seq`

+ `txditc`

– `pstk`

. The definitions of these variables can be found in the above figure. Although `seq`

– `pstk`

= `ceq`

, I have no clue why `txditc`

should be added. Perhaps finance researchers can shed light on this.