Understanding earnings quality - MIT Sloan School of Management

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anks use the valuation allowance against deferred tax assets to create hidden reserves that they can later use to smooth earnings. An additional five papers study the impact of capital requirements relative to other incentives: 1) Moyer (1990) finds that bank’s use adjustments to the loan loss provision, loan charge-offs, and securities gains and losses to avoid violating capital adequacy requirements but she finds no support for the political sensitivity hypothesis (i.e., attempt to reduce income when revenue is high); 2) Beatty, Chamberlain and Magliolo (1995) use a simultaneous system of five equations to examine whether bank managers optimize over a variety of incentives including capital requirements, tax, and earnings goals, and they investigate multiple accruals accounts; 3) Mensah, Considine, and Oakes (1994) suggest that financially weak HMOs understate “incurred but not reported expenses” (IBNRs), consistent with incentives to avoid violation of net worth requirements, but they find no support for the hypothesis that political visibility (measured by size) increases the regulatory pressure; 4) Chen and Daley (1996), for a sample of Canadian banks from 1977 to 1987, find strong support for capital maintenance incentives, weaker support for tax incentives, and no support for equity valuation incentives; and 5) Gaver and Paterson (1999) find that changes in insurers’ choices on the realization of capital gains and stock transactions reflect changing incentives in risk-based capital requirements in 1994, while loss reserve estimates do not. Rather, loss reserve decisions are consistent with tax incentives throughout the period of changing capital regulation. In a related vein, Muller (1999) finds that the decision by British firms to capitalize a brand rather than to write it off immediately at the time of an acquisition is influenced by whether the choice would result in shareholder approval for future acquisitions under London Stock Exchange requirements, which are capital-based. 115
5.6.3 Tax regulations Several studies exploit the LIFO conformity rule in the U.S. tax system to test whether incentives to minimize tax costs (i.e., present value of tax payments) affect accounting method choice, which in turn affects EQ. For example, Lee and Hsieh (1985), Hunt (1985), and Dopuch and Pincus (1988) document both tax (e.g., the magnitude of tax savings) and nontax explanations (e.g., contracting costs) for the choice of inventory accounting methods. Keating and Zimmerman (1999) exploit a natural experiment due to a 1981 tax law change that mitigated the impact of tax considerations on financial reporting depreciation choices and find an increase in the frequency of income-increasing depreciation estimate choices and a decrease in the frequency of income- increasing depreciation method changes after the 1981 tax law change. Guenther, Maydew, and Nutter (1997) exploit a change in book-tax conformity associated with the Tax Reform Act of 1986 (TRA) and find that firms that are required to switch from the cash method to the accrual method have higher (lower) accruals than firms that already use the accrual method prior to (following) the rule change. Five papers in our database examine the effects of rate changes associated with the TRA and suggest that the rate change had a one-time impact on accruals choices around the period of the change. Scholes, Wilson, and Wolfson (1992), Guenther (1994), and Maydew (1997) conclude that firms shift income from the pre-TRA period to the lower tax-rate regime period by deferring revenue and accelerating expenses. The evidence on income shifting in the opposite direction to avoid the U.S. corporate alternative minimum tax (AMT), however, is inconsistent (Boynton, Dobbins, and Plesko, 1992; Choi, Gramlich, and Thomas, 2001). Two additional studies suggest that changes in tax incentives associated with the TRA led to a shift in accounting choices that will affect EQ on an on-going basis. The TRA increased the 116
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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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paper, however, finds that firms ar
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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
Page 147 and 148: Burgstahler, D., Kinney, W., Martin
Page 149 and 150: Considine, J., Mensah, Y., Oakes, L
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Page 153 and 154: Farber, D., 2005. Restoring trust a
Page 155 and 156: Gong, G., Louis, H., Sun, A., 2008.
Page 157 and 158: Hung, M., 2000. Accounting standard
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Page 161 and 162: Malmquist, D., 1990. Efficient cont
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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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