Understanding earnings quality - MIT Sloan School of Management

7. Conclusion
Our approach in this review is to define earnings quality broadly to be decision usefulness –
in any decision by any decision maker. As such, the number of relevant articles numbers over 300,
and by necessity our discussion is broad.
An alternative approach might have been to limit the scope of the review to studies of
decision-usefulness only in an equity valuation context, in accordance with the original use of the
term in financial statement analysis. Under that approach, we would have argued that using the term
earnings quality outside of the equity valuation context is inappropriate, and we would have
criticized the studies that do so and simply ignored them in our review. We would have demanded
that researchers and others not use the term earnings quality outside the context of equity valuation
models. But we believe that ship has sailed and such a recommendation would therefore serve no
purpose. Rather we attempt to understand earnings quality more broadly in its current use.
We emphasize two significant conclusions based on our survey of the earnings quality
literature as a whole. First, because all of the proxies for earnings quality that involve earnings (i.e.,
properties such as persistence, timely loss recognition, smoothness, and small profits, as well as the
ERCs) have at their core the reported accrual-based earnings number, these proxies are affected by
both the firm’s fundamental earnings process and by the measurement of that process. The current
research does not adequately recognize the distinction between the fundamental earnings process and
the measurement of the process, which limits the conclusions we, as a profession, can make to
statements about “earnings quality” rather than about the contribution of accounting measurement to
the quality of reported earnings.
Second, although all of the proxies based on reported earnings are affected by both the
unobservable process and the measurement, the proxies are not equally affected by these two factors.
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