Understanding earnings quality - MIT Sloan School of Management

attention (Aboody et al. , 1999). 71 Both studies predict that macroeconomic factors are correlated
with increased incentives for earnings management. We did not find any studies that hypothesize
macroeconomic conditions as a determinant of earnings quality for other reasons, for example,
because of variation in the ability of accruals to capture performance fundamentals when the
“fundamentals” are different.
6. The consequences of earnings quality
6.1 Capital market consequences of earnings quality
The hypothesized capital market consequences of earnings quality include: short-window
stock price returns around the earnings announcement date, contemporaneous long-window returns,
and future stock price performance after the release of earnings-related information (Section 6.1.1);
market-multiples (Section 6.1.2); cost of equity capital (Section 6.1.3); and cost of debt capital
(Section 6.1.4). 72
6.1.1 Return responses to earnings quality
Contemporaneous short-window returns: In the short-window returns tests, information is assumed
to be of higher quality if it has a higher association with returns. Inferring variation in EQ from the
association between unexpected earnings and returns has been a prevalent research methodology
since the publication of Kormendi and Lipe (1987) and Easton and Zmijewski (1989). The key
findings are:
71 Wilson (1987) finds that his results are driven by two observations (1981 and 1982) and conjectures that the cause
might be a “macroeconomic phenomenon,” given that both were years of significant economic downturn. Bernard and
Stober (1989), however, find no evidence for this conjecture.
72 Many of the studies that examine market consequences use multiple measures and are cited more than once.
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