Understanding earnings quality - MIT Sloan School of Management

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detect and report material misstatements. 62 Fees and size can measure both the auditor’s ability to detect errors and his incentives to report the misstatement. Larger audit firms are negatively associated with discretionary “low quality” accruals. This outcome appears to result from both greater expertise (effectiveness) and stronger incentives to constrain misreporting (DeAngelo, 1981). The auditor size results do not identify whether greater detection ability or greater reporting incentives affect misreporting. The studies on auditor fees and tenure provide some evidence to identify the effects of detection ability versus reporting incentives. Higher audit fees are predicted to be positively correlated with auditor expertise, and hence with detection ability, but they also are predicted to be negatively associated auditor independence and hence with decreased reporting incentives (DeAngelo, 1981). The preponderance of the evidence suggests that higher audit fees and longer auditor tenure are associated with higher accrual quality (or at least not associated with lower quality). This evidence would seemingly suggest that the detection ability effect dominates the independence concerns on average. Studies that attempt to further parse out the independence concerns support this conclusion given that the evidence on revolving door practice and non-audit fees certainly isn’t conclusive that independence is a significant concern. The auditors’ role in affecting earnings quality is limited to a conclusion that auditors specifically constrain income-increasing discretionary accruals. This inference is valid given the auditor’s role in the financial reporting process. Tests that use proxies for EQ other than indicators of earnings management, however, such as ERCs or statistical properties of earnings, are more likely 62 The empirical prediction that auditor characteristics would be associated with an actual number in the income statement (e.g., discretionary accruals) is based on the stronger assumption that auditors not only report the error but that they adjust for it. Evidence in Whittred (1980) calls into question this stronger assumption. Whittred (1980) finds that reporting delays, which could be due to longer auditor-client negotiations and more effort in auditing, are associated with qualified reports. Thus, the auditor has exerted greater effort and detected the error, but the outcome is that earnings quality as reported in the income statement is lower for these firms. The auditor reports the lower quality via the opinion decision. 107
to suffer from omitted correlated variables problems. A significant portion of the cross-sectional variation in ERCs or variables related to properties of earnings (e.g., timely loss recognition and the likelihood of reporting a loss used in Francis and Wang, 2008) comes from the ability of the accounting system to capture the firm’s fundamental earnings process and not from the controllable and auditable dimension of quality. Hence, while the empirical evidence in studies that use ERCs or properties of earnings as proxies for EQ are consistent with the predicted positive relation between auditor effort and earnings quality, the studies must deal with substantial concerns about alternative explanations for results, including auditor self-selection and omitted correlated variables. A notable underrepresented element of the literature is studies that recognize the important roles of entities other than auditors, such as actuaries, that can interact with the auditor to affect the earnings quality outcome (Gaver and Paterson, 2001). Likewise, there are entities other than auditors that have a similar role in the financial reporting process, and thus may affect earnings quality, although research in this area is limited. Morsfield and Tan (2006) document that IPO firms backed by venture capitalists exhibit lower discretionary accruals than other IPO firms in the IPO- year. Jo, Kim, and Park (2007) document that SEOs that have underwriters with higher reputations are associated with lower discretionary accruals than other SEOs. Studies also suggest that institutional investors affect EQ (Bushee, 1998), but the motivation is different. Institutions are predicted to affect EQ because of their anticipated information demands, not because they are directly involved in the financial reporting process. 5.5 Capital market incentives as determinants of earnings quality The papers in this section discuss how capital market incentives influence firms’ accounting choices and hence are potential determinants of earnings quality. 108
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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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lower book values of assets (higher
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than code law countries. The differ
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explain the kink. Durtschi and East
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with overstated net asset values ar
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Page 89 and 90: 5.2 Financial reporting practices a
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Page 131 and 132: 6.1.5 Summary To summarize, the evi
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Page 145 and 146: Beasley, M., 1996. An empirical ana
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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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