Understanding earnings quality - MIT Sloan School of Management

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tools. Barton and Simko (2002) pursue the idea that a firm’s choice with respect to a particular tool might be constrained, but they do not pursue the alternatives when the firm is constrained. A well-recognized problem with studies that use analyst forecasts as a benchmark is that the analyst is an economic agent with his own incentives. Beating an analyst forecast depends not only on the firm’s accounting choices, which may affect earnings quality, but also on the analyst’s forecasting actions. The studies interpret a relation between “meeting or beating” the forecast and earnings management as evidence that the firm managed earnings, while the alternative explanation is that the analyst managed the forecast (Richardson, Teoh, and Wysocki, 2004). To the extent the analyst’s actions are influenced by earnings quality considerations (unmanaged), the net impact on earnings quality arising from these incentives is indeterminate 5.6 External factors as determinants of earnings quality conditions. External factors include political processes, tax and non-tax regulation, 66 and macroeconomic 5.6.1 The political process Eight papers in our database predict that political processes motivate managers to engage in income-decreasing earnings management, commonly measured by discretionary accruals, during periods of political pressure because profits generate regulatory or political attention/scrutiny that can lead to costly intervention or because profits are a direct input to a political/regulatory decision. The settings examined include: 1) U.S. International Trade Commission import relief investigations 66 Regulators and regulation may be viewed as external monitors like auditors and boards, discussed in Sections 3.3 and 3.4. Consistent with the Kose and Kedia (2006) framework for internal controls, however, regulation is discussed as a distinct determinant of earnings quality because it is a force imposed on the firm rather than a monitoring choice made by the firm. 113
(Jones, 1991); 2) Department of Justice/Federal Trade Commission antitrust investigations (Cahan, 1992); 3) Political pressure on HMOs (Mensah, Considine, and Oakes, 1994); 4) Congressional hearings on the U.S. cable television industry (Key, 1997); 5) Oil companies during the 1990 Gulf crisis (Han and Wang, 1998); 6) New Zealand’s Price Justification Scheme and the Stabilisation of Prices Regulation in the 1970s (Navissi, 1999); 7) Gold price inflation, proposed taxes, and gold firms in Australia (Monem, 2003); and 8) Environmental Protection Agency pressures on potentially responsible parties (PRP) under the Superfund Act (Johnston and Rock, 2005). The studies investigate a wide variety of settings, but they consistently document that expected political costs affect accounting choices (Watts and Zimmerman, 1986). An assumption common to these studies is that the decision-maker uses the reported earnings number in his decision and does not undo the effects of the accounting choice. 67 Thus, it is not surprising that these papers investigate discretionary accruals rather than other potentially more transparent accounting choices such as accounting method changes. 5.6.2 Capital regulations Four papers focus exclusively on the relation between incentives to meet capital requirements and earnings management behavior. They use either levels or changes specifications to test for the relation: 1) Petroni (1992) finds that P&C insurers experiencing financial difficulty underestimate policy loss reserves, consistent with incentives provided by insurance industry net worth requirements; 2) Kim and Kross (1998) and Ahmed, Takeda, and Thomas (1999) find that the magnitude of loan loss provisions for banks with low capital ratios significantly decreased after new capital standards became effective in 1989; 3) Schrand and Wong (2003) find that well-capitalized 67 The firm may only need to fool a politician’s constituents, which provides the politician with enough justification to support his position, even if the politician is able to unravel the underlying facts. 114
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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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earnings quality. The studies speci
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to conservatism, which is defined a
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they assert proxy for lower indepen
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Page 89 and 90: 5.2 Financial reporting practices a
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Page 93 and 94: The notion that accounting method c
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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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Page 149 and 150: Considine, J., Mensah, Y., Oakes, L
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Page 157 and 158: Hung, M., 2000. Accounting standard
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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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