Understanding earnings quality - MIT Sloan School of Management

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6.1.3 Earnings quality and cost of equity capital The proxies used for cost of capital include: 1) A firm’s implied or ex ante cost of equity capital, which is the discount rate that equates current market value with the sum of the present value of expected future cash flows in an equity valuation model; 2) bid-ask spreads; and 3) beta. 73 We conclude this section with a discussion of the emerging literature on accrual quality as a priced risk factor. Implied cost of equity capital: Francis et al. (2004), discussed extensively in Section 3, find that accrual quality, earnings persistence, smoothness, value relevance, and timeliness are associated with cost of equity capital in the predicted direction, while predictability and conservatism are not. 74 Accrual quality has the largest cost of equity capital effects. Bhattacharya, Daouk, and Welker (2003) find evidence of an association between country-level earnings quality measures including earnings aggressiveness (i.e., accruals), loss avoidance, and earnings smoothing, and country-level measures of total cost of capital. Hribar and Jenkins (2004) suggest that restatements are associated with increases in the implied cost of equity capital. There is mixed evidence on whether revelations of internal control deficiencies affect a firm’s cost of equity capital (Beneish et al., 2008; Ogneva et al., 2007; Ashbaugh-Skaife et al., 2009). Auditor independence is associated with a lower implied cost of equity capital for the audit client (Khurana and Raman, 2006). 73 See Frankel and Lee (1998), Botosan and Plumlee (2002), Kasznik (2004), Brav et al. (2004), Easton and Monahan (2005), and Botosan and Plumlee (2005) for specifications and discussions of implied cost of equity capital metrics. See Callahan, Lee, and Yohn (1997) and Mohanram and Rajgopal (2009) for discussions of spreads (and PIN) as measures of the adverse selection component of the cost of capital. See Section 3.1 for an extensive discussion of Francis et al. (2005), which provides evidence on accrual quality as a priced risk factor. 74 However, McInnis (2009) does not find evidence of higher average stock returns for firms with high earnings smoothness. He suggests that the association between earnings smoothness and cost of equity capital documented in prior research is driven by optimism in analysts’ long-term earnings forecasts. 125
Bid-ask spread: Evidence on the association between earnings quality and bid ask spreads is mixed and appears to depend heavily on the EQ proxy. Dechow et al. (1996) find an increase in residual bid ask spread for AAER firms. Chang et al. (2006) find that SOX requirements concerning CEO/CFO certifications are associated with lower spreads. Palmrose et al. (2004), however, do not find evidence of a significant change in spreads subsequent to restatements. There is a negative association between earnings predictability and bid-ask spreads (Affleck- Graves et al., 2002), but a U-shaped relation between smoothness and spreads (Jayaraman, 2008). The smoothness measure is the difference between earnings volatility and cash flow volatility, so the result suggests that when earnings are too smooth relative to cash flows, or much more volatile, then market prices appear to reflect greater asymmetry. Beta: Loss reserve revisions of P&C insurers as a measure of discretionary accruals (Petroni, Ryan, and Wahlen, 2000) and internal control deficiencies (Ashbaugh-Skaife et al., 2009) are positively associated with beta. Accrual quality as a priced risk factor: Francis et al. (2005) (FLOS) rank their measure of accrual quality (discussed in Section 3.1.1) into quintiles and show variation across the quintiles in the cost of debt (interest to average debt), industry adjusted EP ratios, and betas from CAPM type regressions. They also calculate the difference in returns each month between the top two quintiles and the bottom two quintiles and determine whether the AQ factor is priced (has a significant coefficient): Rj,m- Rf,m = αj+βj(RM,m- Rf,m)+sjSMBm + hjHMLm + ejAQfactorm + εjm FLOS find a significant coefficient on ej. When the AQ factor is decomposed into the innate and discretionary component, they find that the result is driven mainly by the innate component although 126
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*Title Page/Author Identifier Page/
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Street equity valuation model as ea
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earnings quality proxy is the indep
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of fundamental earnings will be a f
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contributions of the fundamental co
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accruals, in total or individually,
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While we identify these contradicti
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Proxies for asymmetric timeliness b
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sample. Hence, sample specific char
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unintentional misstatements, which
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Empirical studies have examined mul
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there are (in theory) predictable a
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is primarily driven by the firm’s
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methodology. Studies could make uni
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The discussion of earnings persiste
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and documents that β2 < β1, which
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1993). 12 The studies find conflict
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Xie (2001) uses the Jones model (di
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sophisticated investors do understa
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measurement. Nwaeze, Yang, and Yin
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and better reflects revenue manipul
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All of the accruals models can be e
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Second, investors seem to recognize
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fact improve predictability relativ
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lower book values of assets (higher
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than code law countries. The differ
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explain the kink. Durtschi and East
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with overstated net asset values ar
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earnings quality. The studies speci
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to conservatism, which is defined a
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they assert proxy for lower indepen
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paper, however, finds that firms ar
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Debt covenants: Dechow et al. (1996
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eadjustments in valuations associat
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ange of misstatements and they are
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significantly change the historical
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the firm’s public accountants mus
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