Understanding earnings quality - MIT Sloan School of Management

(that excludes depreciation); (iii) the absolute value of the residual from a Dechow and Dichev
model; (iv) the standard deviation of the residual from (iii) using the time-series of the firm’s
residual (i.e., as in FLOS). Aboody, Hughes, and Liu (2005) find that a mimicking portfolio strategy
that buys firms with high AQ beta earns positive abnormal returns earns positive abnormal returns.
Core et al., however, find that this result is sensitive to the time period examined. They find no
results when using a longer time horizon. In addition, Aboody et al. conclude that the AQ_factor
loading is weak, particularly compared to the returns on their insider trading results.
6.1.4 Debt market consequences of earnings quality
Only three consequences papers in our database extend the definition of earnings quality to
decision usefulness in debt markets. Francis et al. (2005) find that firms with lower quality accruals
have a higher cost of debt measured by: 1) the ratio of interest expense to interest-bearing
outstanding debt (i.e., an ex post measure), and 2) S&P Issuer Credit Ratings (i.e., an ex ante
measure). Anderson et al. (2004) find that firms with higher board independence, higher audit
committee independence, and larger board size have lower costs of debt measured as the yield
spread. They cite prior empirical studies (e.g., Klein, 2002) to justify these indirect proxies for
financial reporting quality. Bhojraj and Swaminathan (2007) find that one-year ahead bond returns
of firms with high operating accruals are significantly lower than those of firms with low operating
accruals, consistent with bond investors mispricing high and low accrual firms in much the same
way that equity investors do.
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