Understanding earnings quality - MIT Sloan School of Management

1) The market responds more favorably when earnings are composed of cash flows than accruals
(Wilson, 1987). Bernard and Stober (1989), however, find that the results in Wilson (1987) are
driven by two quarters.
2) Investors discount discretionary accruals if they are made aware of them or if they can infer that
they are more likely to represent earnings management (DeFond and Park, 2001; Balsam, Bartov,
and Marquardt, 2002; Baber, Chen, and Kang, 2006; Gleason and Mills, 2008; Coles, Hertzel, and
Kalpathy, 2006). Louis and Robinson (2005) similarly find that when managers combine
discretionary accruals with another credible signal (i.e., a stock split), investors do not discount
them.
3) Negative special items (write-offs or write-downs) are generally associated with a small negative
stock price reaction of around one percent (Elliott and Shaw, 1988). When a firm has a history of
special items, the response coefficient associated with earnings before special items receive a lower
weight (Elliot and Hanna, 1996). Variation in reactions to inventory write-offs and restructuring
charges suggest that they convey information about expected future performance (Francis, Hanna,
and Vincent, 1996).
4) Investors respond more strongly to pro-forma earnings than to GAAP earnings on average
(Bhattacharya, Black, Christensen, and Larson, 2003). The coefficient is only significant for firms
with relatively less informative GAAP earnings, as measured by historical ERCs (Lougee and
Marquardt, 2004).
5) Indicators of general financial reporting quality concerns are associated with negative stock price
reactions. There is a strong negative stock market reaction to announcements of restatements and/or
AAERs (Feroz et al., 1991; Dechow et al., 1996; and Palmrose, Richardson, and Scholz, 2004). The
evidence is consistent, but the implications for EQ are ambiguous (see Section 3.3). The revelation
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