Understanding earnings quality - MIT Sloan School of Management

of internal control procedure deficiencies as required under SOX Section 302 generate small
negative stock responses of around 2 percent (Hammersley, Myers, and Shakespeare, 2008; Beneish,
Billings, and Hodder, 2008). Announcements about audit fees that may indicate to investors that
earnings are of low quality are associated with negative short window returns (Frankel, Johnson, and
Nelson, 2002; Hackenbrack and Hogan, 2002).
6) Earnings with qualified audit opinions are associated with either negative price reactions
(Dopuch, Holthausen, and Leftwich 1986; Choi and Jeter 1992; Chen, Su, and Zhao, 2000) or no
reaction (Chow and Rice, 1982; Dodd et al., 1984).
Contemporaneous long-window returns (association studies): Many early studies examine whether
earnings measured under different methods result in different market consequences. A series of
early papers conclude that investors interpret financial statement information conditional on the
accounting method used (Mlynarczyk, 1969; Archibald, 1972; Ball, 1972; Gonedes, 1975 and 1978;
Harrison, 1977; Sunder, 1975). Other studies, however, challenge these results or present new
analyses that suggest that analysts and other subjects tend to be functionally fixated on earnings
(Dyckman, 1964; Kaplan and Roll, 1972; Cassidy, 1976; Harrison, 1977). These studies make
cross-sectional predictions about which methods reflect underlying economics to infer investor
rationality. More recently, Loudder and Behn (1995) use a similar methodology and conclude that
investors understand R&D accounting based on predicted patterns in long window ERCs. Altamuro,
Beatty, and Weber (2005) however, assume that markets rationally interpret revenue recognition
practices and interpret patterns in long-window ERCs as evidence that pre-SAB 101 earnings are
more useful for firms that were required to switch than earnings measured based on SAB 101.
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