Understanding earnings quality - MIT Sloan School of Management

Equity market incentives receive little support as a determinant of accounting choices when
measured relative to incentives provided by external factors. However, the tests of equity market
incentives are likely to be of low power relative to tests of incentives provided by regulatory capital
requirements to manage specific accounts such as the loan loss provision.
The earnings management activities associated with these external factors may potentially
mislead other financial statement users. We did not catalogue any studies on how/whether firms
communicate to equity markets during periods of regulatory scrutiny to offset the negative message
they falsely send to regulators/politicians, or the extent to which firms may forgo accessing capital
during these periods. We also did not catalogue any studies that assess equity market reactions to
earnings during these periods when investors might rationally infer the earnings management. 70
Several papers provide evidence that firms use multiple tools in response to a single
incentive. These results emphasize a point we have made previously: accruals management, ceteris
paribus, may impair earnings quality, but it represents only one choice within the firm’s portfolio of
accounting and real choices. Hunt, Moyer, and Shevlin (2000) examine both multiple tools and
multiple incentives.
Finally, there is (surprisingly) limited research on macroeconomic conditions as a
determinant of EQ. Although we had initially defined a category to collect these papers, our journal
search found only one paper that focuses primarily on macroeconomic factors as a determinant of
earnings quality (Liu and Ryan, 2006) and one paper that gives them significant albeit secondary
70 Two studies, however, provide related discussions/evidence. Ronen and Aharoni (1989) develop a model that shows
that higher tax rates are associated with choices of income-increasing accounting methods, excepting accounting
methods subject to book tax conformity. A key assumption of the model is that equity market participants will see
through the earnings management and value the firm’s equity correctly. Beatty and Harris (1999) compare security gains
and losses in public banks to those in private banks, both of which are subject to capital requirements, to determine how
earnings management differs under the assumption that public banks have greater incentives to engage in earnings
management than private banks due to equity market incentives. However, this paper does not test how and when banks
trade-off the equity market incentives against other earnings management incentives that firms face.
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