Understanding earnings quality - MIT Sloan School of Management

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In summary, while we may be able to characterize earnings persistence and conclude that firms with more persistent earnings have more accurate equity valuations, which implies greater decision usefulness, we have relatively less to say about the importance of the measurement process in reaching these conclusions. By clarifying and distinguishing between fundamentals and the accounting measurement system, more insights could be obtained about the role of the measurement system itself. Earnings smoothness (Section 3.1.2): As noted in the introduction, the commonly-used smoothness proxies are negatively correlated with the other EQ proxies (Table 1). Because smoothness is based on the reported earnings number, it will have a fundamental component that represents the smoothness of the firm’s fundamental earnings process. The other EQ proxies such as persistence, timeliness, or value-relevance, however, also are affected by the fundamental earnings process and the application of the measurement system to that process. Hence, the negative correlation suggests that the application of accounting measurement to the fundamental process does not have the same impact on resulting smoothness properties of reported earnings as it does for the other proxies. 5 Another finding that is different for smoothness than for the other EQ proxies is that the limited literature that has examined the use of discretionary accruals to artificially smooth earnings (by U.S. firms) suggests that smoothing is value-relevant rather than opportunistic (e.g., Subramanyam, 1996, and Tucker and Zarowin, 2005). 5 Ewert and Wagenhofer (2009) just recently distributed a working paper that models a firm’s accounting choices over a single earnings process and measures various properties of the reported earnings including smoothness, persistence, and value relevance. Each of these commonly used proxies for earnings quality is evaluated relative to an unobservable but known construct in their model that represents the reduction in the variance of the terminal value in an equity valuation model associated with reported earnings. Likewise, Basu (1997) shows that persistence, asymmetric timeliness, and ERCs are related properties. 11
While we identify these contradictions between smoothness and the other EQ proxies, we are short on explanations. There is little research that attempts to ascertain the “normal” component of smoothness that results from unbiased application of an accrual process to the firm’s unobservable fundamental earnings process. As shown in Figure 1, only three papers in our database examine fundamental firm characteristics and smoothness proxies and one finds negative evidence. Smoothness has generated more consistent results as a proxy for earnings quality, and in particular for earnings management, in cross-country studies. The international evidence suggests that there is a significant component of smoothness that is artificial and that represents opportunistic earnings management. This finding, which contrasts with the limited findings in the U.S., may result from the ability to create a smoothness proxy that captures cross-sectional variation in artificial smoothing or earnings management. In international studies, researchers typically benchmark earnings smoothness against the smoothness of operating cash flows (e.g., Leuz, Nanda, and Wysocki, 2003). In these settings, the cross-sectional variation in the discretionary component of smoothness may dominate the measurement error in the fundamental component of smoothness, which makes the “abnormal smoothness” measure a reasonable proxy for earnings management. More research could be done to explain the inconsistencies between the firm-level results in the U.S. versus the country level results. In summary, the ability of smoothness to capture 1) the smoothness of a firm’s fundamental earnings process, 2) the smoothness induced by the unbiased application of an accounting measurement system to that process, and 3) the effect of intentional distortions on smoothness, is still very much an open question. 12
Page 1 and 2: *Title Page/Author Identifier Page/
Page 3 and 4: Street equity valuation model as ea
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Page 17 and 18: sample. Hence, sample specific char
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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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whether disclosure of material weak
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with “shareholder” corporate go
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accruals) that stems from the confl
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observable variables such as natura
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and do not appear to be made to boo
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firms identified in the AAERs than
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past service costs). Zmijewski and
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5.2 Financial reporting practices a
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5.2.2 Other financial reporting pra
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The notion that accounting method c
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quality and the quality of M&A deci
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In countries with high ownership co
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for the AAER firm executives than f
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Dechow and Sloan (1991), who study
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management related to incentives pr
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nonaudit fees) and discretionary ac
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errors when litigation risk is high
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to suffer from omitted correlated v
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capital accruals as a proxy. Perry
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how the incentives provided by the
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(Jones, 1991); 2) Department of Jus
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5.6.3 Tax regulations Several studi
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importance of implicit claims, they
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attention (Aboody et al. , 1999). 7
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of internal control procedure defic
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differences, which investors ration
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Bid-ask spread: Evidence on the ass
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low accrual quality stock that are
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6.1.5 Summary To summarize, the evi
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plaintiffs will prevail in sharehol
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income increasing restatement firms
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evisions do not fully account for t
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the fact that some disclosures are
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Therefore, the proxies are not meas
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Amir, E., Harris, T., Venuti, E., 1
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Beasley, M., 1996. An empirical ana
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Burgstahler, D., Kinney, W., Martin
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Considine, J., Mensah, Y., Oakes, L
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Desai, H., Rajgopal, S., Venkatacha
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Farber, D., 2005. Restoring trust a
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Gong, G., Louis, H., Sun, A., 2008.
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Hung, M., 2000. Accounting standard
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Kothari, S., Leone, A., Wasley, C.,
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Malmquist, D., 1990. Efficient cont
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Phillips, F., 1999. Auditor attenti
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Tucker, J., Zarowin, P., 2006. Does
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Figure 1. Summary of the investigat
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Figure 3: Key links between determi
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Table 1. Categories of “Earnings
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Exhibit 1: Summary of earnings qual
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Exhibit 2: Summary of widely used m
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