Understanding earnings quality - MIT Sloan School of Management

Despite the long-standing recognition that optimal contracts, and more generally internal
controls as defined by Jensen and Meckling (1976), may lead to accounting choices that benefit the
agent at the expense of the firm (i.e., opportunistic earnings management) or to efficient accounting
choices that maximize the value of the firm, the debate is still open. 57 Christie and Zimmerman
(1994) and Bowen et al. (2008) examine which of these two alternative explanations is dominant in
explaining observed discretionary accounting choices. Both papers conclude that contracting
efficiency is the main explanation. In addition, Bowen et al. (2008) find that accounting discretion
associated with poor controls is positively related to future operating performance (i.e., operating
cash flows and return on assets), which they interpret as evidence that earnings management is
beneficial to shareholders.
Their findings raise the question of whether and when equityholders recognize that
discretionary accounting choices are ex post efficient vs. opportunistic. Christie and Zimmerman
(1994) assume that the takeover market would discipline opportunism and use this to identify a
sample of firms that are likely to be opportunistic. While it is reasonable to assume that participants
in the takeover market can unwind earnings management, it is an empirical question whether equity
investors, or other parties such as analysts, are able to unwind earnings management. The stock
option grant papers provide evidence that equity investors infer that earnings may be managed
around grant dates and incorporate an expectation of rational earnings management into their
pricing. However, research that explores the extent to which equity investors infer rational earnings
57 Dye and Verrecchia (1995), Fischer and Verrecchia (2000), and Stocken and Verrecchia (2004) use varied modeling
techniques to yield predictions about accounting method choice and conditions that affect efficiency. The predictions
about accounting choices, including disclosure, depend on the parameterization of the model and the assumptions about
the contracting environment, information asymmetry, and the costs to the manager of various firm decisions. Managers
sometimes choose accounting methods to convey information and sometimes choose methods that intentionally increase
the noise in financial reports. Discretion sometimes improves efficiency but sometimes decreases it. The choice of a
more noisy financial reporting system can be associated with increased efficiency, which may seem to be an unintuitive
result.
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