Understanding earnings quality - MIT Sloan School of Management

importance of implicit claims, they propose that implicit customer claims are positively associated
with product uniqueness, and they measure variation in uniqueness by R&D expense. Rosner (2003)
finds that firms that subsequently declare bankruptcy have greater income-increasing abnormal
accruals compared to a matched sample and suggests that the firms engaged in earnings management
in an effort to avoid bankruptcy.
5.6.6 Summary
Capital regulations, specifically in the banking and insurance industries, provide strong
incentives to manage earnings, and loss provisions are most commonly used to meet these
regulations. Other incentives are of second-order importance when capital requirements are likely to
be binding. 69
The studies document that firms manage discretionary accruals during periods of heightened
pressure (either external or internal) or in response to specific regulatory changes. Thus, the results
suggest that earnings quality is time-varying. External factors such as changing pressures from
antitrust regulation during merger discussions will create firm-specific time-varying EQ patterns.
However, the majority of the external factors discussed are clustered in calendar time (e.g., the TRA
or bank capital requirement changes) and the resulting effects on EQ will be clustered in calendar
time as well. External factors that affect accounting method choice, in contrast, will lead to cross-
sectional variation in EQ, but not time-variation (Calegari, 2000; Klassen, Lang, and Wolfson,
1993).
69 This conclusion on net worth requirements, however, may not generalize to other settings. The financial services
industry has greater power to detect specific earnings management responses to regulations given the direct link between
the capital requirements and the loss provision accounts and the significance and variation of the loss provision accounts
across banks/insurance carriers.
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