Understanding earnings quality - MIT Sloan School of Management

More documents

Recommendations

Info

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. 139
Therefore, the proxies are not measures of the same underlying construct, but rather they measure different elements of decision usefulness. We hope the breadth of the discussion of each proxy has shed light on the context-specific dimensions of quality captured by each proxy and on the sometimes subtle distinctions between them. We introduced Figures 1 and 2 in the introduction to illustrate the earnings quality proxies that have been used to test the theoretical determinants and consequences of earnings quality. Our objective in providing Figures 1 and 2 is not to suggest that researchers fill in the mosaic. A significant point of this review is that the earnings quality proxies measure different facets of quality, and an implication of this statement is that not all of the cells in the figures represent sensible hypotheses. It may be worth investigating certain cells, not because the theory predicts a relation, but because not finding a relation would provide useful counterfactual evidence. The figures do, however, highlight some potential opportunities for future research. For example, SOX internal control deficiency firms provide a relatively new opportunity to examine the consequences of financial statement reliability. The implications of benchmarking for compensation and analysts’ decisions also are interesting areas for future research. We emphasize, however, that careful research design and a clearer understanding of the strengths and weaknesses of these proxies in the setting examined is important for establishing a meaningful result. Throughout the review, we noted situations where we think the inferences are weak because we question the hypothesized relation between a particular determinant and EQ or between EQ and a particular consequence. Most of the problem stems not from a weak theory but from treating the earnings quality proxies as substitutes for each other and not precisely matching the theory to the construct. 140
Page 1 and 2:
*Title Page/Author Identifier Page/
Page 3 and 4:
Street equity valuation model as ea
Page 5 and 6:
earnings quality proxy is the indep
Page 7 and 8:
of fundamental earnings will be a f
Page 9 and 10:
contributions of the fundamental co
Page 11 and 12:
accruals, in total or individually,
Page 13 and 14:
While we identify these contradicti
Page 15 and 16:
Proxies for asymmetric timeliness b
Page 17 and 18:
sample. Hence, sample specific char
Page 19 and 20:
unintentional misstatements, which
Page 21 and 22:
Empirical studies have examined mul
Page 23 and 24:
there are (in theory) predictable a
Page 25 and 26:
is primarily driven by the firm’s
Page 27 and 28:
methodology. Studies could make uni
Page 29 and 30:
The discussion of earnings persiste
Page 31 and 32:
and documents that β2 < β1, which
Page 33 and 34:
1993). 12 The studies find conflict
Page 35 and 36:
Xie (2001) uses the Jones model (di
Page 37 and 38:
sophisticated investors do understa
Page 39 and 40:
measurement. Nwaeze, Yang, and Yin
Page 41 and 42:
and better reflects revenue manipul
Page 43 and 44:
All of the accruals models can be e
Page 45 and 46:
Second, investors seem to recognize
Page 47 and 48:
fact improve predictability relativ
Page 49 and 50:
lower book values of assets (higher
Page 51 and 52:
than code law countries. The differ
Page 53 and 54:
explain the kink. Durtschi and East
Page 55 and 56:
with overstated net asset values ar
Page 57 and 58:
earnings quality. The studies speci
Page 59 and 60:
to conservatism, which is defined a
Page 61 and 62:
they assert proxy for lower indepen
Page 63 and 64:
paper, however, finds that firms ar
Page 65 and 66:
Debt covenants: Dechow et al. (1996
Page 67 and 68:
eadjustments in valuations associat
Page 69 and 70:
ange of misstatements and they are
Page 71 and 72:
significantly change the historical
Page 73 and 74:
the firm’s public accountants mus
Page 75 and 76:
whether disclosure of material weak
Page 77 and 78:
with “shareholder” corporate go
Page 79 and 80:
accruals) that stems from the confl
Page 81 and 82:
observable variables such as natura
Page 83 and 84:
and do not appear to be made to boo
Page 85 and 86:
firms identified in the AAERs than
Page 87 and 88:
past service costs). Zmijewski and
Page 89 and 90: 5.2 Financial reporting practices a
Page 91 and 92: 5.2.2 Other financial reporting pra
Page 93 and 94: The notion that accounting method c
Page 95 and 96: quality and the quality of M&A deci
Page 97 and 98: In countries with high ownership co
Page 99 and 100: for the AAER firm executives than f
Page 101 and 102: Dechow and Sloan (1991), who study
Page 103 and 104: management related to incentives pr
Page 105 and 106: nonaudit fees) and discretionary ac
Page 107 and 108: errors when litigation risk is high
Page 109 and 110: to suffer from omitted correlated v
Page 111 and 112: capital accruals as a proxy. Perry
Page 113 and 114: how the incentives provided by the
Page 115 and 116: (Jones, 1991); 2) Department of Jus
Page 117 and 118: 5.6.3 Tax regulations Several studi
Page 119 and 120: importance of implicit claims, they
Page 121 and 122: attention (Aboody et al. , 1999). 7
Page 123 and 124: of internal control procedure defic
Page 125 and 126: differences, which investors ration
Page 127 and 128: Bid-ask spread: Evidence on the ass
Page 129 and 130: low accrual quality stock that are
Page 131 and 132: 6.1.5 Summary To summarize, the evi
Page 133 and 134: plaintiffs will prevail in sharehol
Page 135 and 136: income increasing restatement firms
Page 137 and 138: evisions do not fully account for t
Page 139: the fact that some disclosures are
Page 143 and 144: Amir, E., Harris, T., Venuti, E., 1
Page 145 and 146: Beasley, M., 1996. An empirical ana
Page 147 and 148: Burgstahler, D., Kinney, W., Martin
Page 149 and 150: Considine, J., Mensah, Y., Oakes, L
Page 151 and 152: Desai, H., Rajgopal, S., Venkatacha
Page 153 and 154: Farber, D., 2005. Restoring trust a
Page 155 and 156: Gong, G., Louis, H., Sun, A., 2008.
Page 157 and 158: Hung, M., 2000. Accounting standard
Page 159 and 160: Kothari, S., Leone, A., Wasley, C.,
Page 161 and 162: Malmquist, D., 1990. Efficient cont
Page 163 and 164: Phillips, F., 1999. Auditor attenti
Page 165 and 166: Tucker, J., Zarowin, P., 2006. Does
Page 167 and 168: Figure 1. Summary of the investigat
Page 169 and 170: Figure 3: Key links between determi
Page 171 and 172: Table 1. Categories of “Earnings
Page 173 and 174: Exhibit 1: Summary of earnings qual
Page 175: Exhibit 2: Summary of widely used m
show all

Understanding earnings quality - MIT Sloan School of Management

You also want an ePaper? Increase the reach of your titles

Delete template?

Save as template?