Understanding earnings quality - MIT Sloan School of Management

Reviewing these studies together yields the following conclusions:
1) Evidence consistently suggests that incentives to influence equity market valuations affect firms’
accounting choices, in particular their accrual choices. The hypothesis that equity markets would
provide incentives for these accounting choices assumes that equity markets cannot detect the
earnings management, although the papers do not test this. The papers provide evidence only on
whether managers believe that the specific mechanism they examine is detectable.
2) The papers generally focus on event-driven incentives for accounting choices. These accounting
choices, however, can have long-term consequences, such as a diminished reputation for
transparency that adverse selection models predict should have a negative impact on the firm’s cost
of capital. 64 The studies generally do not emphasize the trade-off between the short-term benefits of
the accounting choice at the time of the event (e.g., the IPO) and the potential long-term reputation
loss due to these one-off earnings management decisions.
In fact, the finding that IPO cross-listed firms and non-IPO cross-listed firms have similar
levels of accruals management (Ndubizu, 2007) suggests that the expected benefits of investor
recognition (or visibility), rather than capital raising activities, provides incentives for accounting
choices. Similarly, Bowen et al. (2002) find a positive association between levels of activity on
Motley Fool and use of the gross basis of reporting for advertising barter arrangements, which
suggests that firms use accounting choice to influence visibility. Like reputation discussed in the
previous paragraph, investor recognition is a long-term objective that may influence a firms’
accounting choices. While the importance of investor recognition is recognized in other areas of
accounting research (e.g., studies of investor relations and analysts), little research directly examines
64 Christie and Zimmerman (1994) find that takeover targets are more likely to be using income increasing accounting
choices than an industry matched sample. The choices they examine have only a small effect on income but have a
substantial impact on retained earnings over long periods. They argue that these choices reflect “economic Darwinism.”
Firms that use suboptimal accounting choices, or that select the accounting rules for opportunistic reasons rather than
signaling reasons, are more likely to be taken over.
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