Understanding earnings quality - MIT Sloan School of Management

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accruals) downward in the year of the change. Pourciau (1993) also shows that earnings tend to be managed upward in the year following management change. Incoming managers can blame departing managers for asset impairments. In addition, they can lower the earnings benchmark against which future results are evaluated or create hidden reserves to manage future earnings. Dechow and Sloan (1991) document that departing CEOs are more likely to cut R&D expenditures when they are closer to retirement. The shorter career horizon creates stronger incentives to focus on short-term operating performance at the expense of long-term operating performance. Pourciau (1993), however, does not find evidence that managers use accruals that increase earnings during their last year with the firm. DeAngelo (1988) finds evidence that managers use accounting discretion (i.e., abnormal accruals) to report favorable accounting earnings during a proxy contest for board seats after having been targeted by dissidents for poor earnings performance. She also finds evidence of big-bath earnings management behavior when dissidents are elected following proxy contests. In follow-up research, Collins and DeAngelo (1990) find that the market is more responsive to earnings during the proxy contest, which is opposite to the expected result if investors anticipate that managers are using accounting discretion to boost earnings. The question of managerial turnover and more generally the impact of individual characteristics of a manager on earnings management is important but the evidence is limited (see Francis, Huang, Rajgopal and Zang, 2008; Schrand and Zechman, 2009; Ge, Matsumoto and Zhang, 2009). Studies of the implications of manager change face two hurdles. First, it is difficult to control for factors such as performance that could cause management turnover/selection and simultaneously affect EQ proxies. Second, in studies of departures, it is difficult to identify whether and when managers expect to depart. This difficulty might explain the difference in results in 99
Dechow and Sloan (1991), who study retirees with expected departure dates, and Pourciau (1993), who studies non-routine executive turnover. 5.3.6 Summary of governance and controls as determinants of earnings quality The evidence that internal control procedures are associated with less earnings management and that managerial turnover is a disciplining mechanism associated with earnings management, as a specific dimension of earnings quality, is generally consistent. The evidence on how other governance mechanisms and controls (i.e., BOD characteristics, managerial ownership, and managerial compensation) affect earnings management is weak or mixed. A notable deficiency of this literature is that our database contains no studies that attempt to understand whether managers internalize the earnings quality implications of investment and financing decisions. Governance mechanisms and controls (other than internal control procedures) may not have a direct effect on earnings management, but these mechanisms likely do affect other managerial decisions, which in turn can affect dimensions of earnings quality. For example, characteristics of the BOD will affect investment decisions, and investment can affect earnings persistence and sustainability (Penman and Zhang, 2002). Likewise, an extensive literature documents an association between equity-based compensation and investment decisions, but our database does not contain any studies that attempt to predict that equity-based compensation will have consequences for EQ proxies other than earnings management. This omission is surprising given that variation in compensation contract form is commonly predicted to affect variation in investment risk-taking (e.g., Shevlin and Rajgopal, 2002), which is associated with earnings sustainability and persistence, two prominent measures of earnings quality. 100
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*Title Page/Author Identifier Page/
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Street equity valuation model as ea
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earnings quality proxy is the indep
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of fundamental earnings will be a f
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contributions of the fundamental co
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accruals, in total or individually,
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While we identify these contradicti
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Proxies for asymmetric timeliness b
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sample. Hence, sample specific char
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unintentional misstatements, which
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Empirical studies have examined mul
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there are (in theory) predictable a
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is primarily driven by the firm’s
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methodology. Studies could make uni
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The discussion of earnings persiste
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and documents that β2 < β1, which
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1993). 12 The studies find conflict
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Xie (2001) uses the Jones model (di
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sophisticated investors do understa
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measurement. Nwaeze, Yang, and Yin
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and better reflects revenue manipul
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All of the accruals models can be e
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Second, investors seem to recognize
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fact improve predictability relativ
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Desai, H., Rajgopal, S., Venkatacha
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Farber, D., 2005. Restoring trust a
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Gong, G., Louis, H., Sun, A., 2008.
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Hung, M., 2000. Accounting standard
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Kothari, S., Leone, A., Wasley, C.,
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Malmquist, D., 1990. Efficient cont
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Phillips, F., 1999. Auditor attenti
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Tucker, J., Zarowin, P., 2006. Does
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Figure 1. Summary of the investigat
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Figure 3: Key links between determi
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Table 1. Categories of “Earnings
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Exhibit 1: Summary of earnings qual
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Exhibit 2: Summary of widely used m
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