Understanding earnings quality - MIT Sloan School of Management

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Timely loss recognition/Asymmetric timeliness (Section 3.1.3): Timely loss recognition measures get more at the heart of the distinction between the quality of the fundamental earnings process (X) and the ability of the accounting system to measure the process (e) than the other EQ proxies. A stronger association of earnings with negative stock returns is more likely to be related to the application of financial reporting rules to a fundamental earnings process than to be a feature of the process itself (since stock returns are not an output of the accrual accounting system). However, differences in timely loss recognition within countries (or regions) with the same standards or legal origin suggest that timely loss recognition has an endogenous component related to firms’ reporting incentives. It is not driven purely by a country’s accounting system. Using the returns-based measure of timely loss recognition as proxies for quality, however, requires that the researcher consider two significant issues. First, variation in asymmetric timeliness may reflect variation in the ability of earnings to capture value relevant information, as generally predicted, or it may be evidence of variation in the ability of returns to reflect value relevant information. The assumption of market efficiency that underlies the interpretation of returns-based metrics as a measure of earnings informativeness is not likely to hold equally across markets, which will induce omitted correlated variables bias. This issue is of particular concern in cross-country studies due to significant differences in market microstructure and macroeconomic conditions. 6 Second, returns reflect all information, not just information in earnings. If more conservative accounting, conditional or unconditional, is correlated with the production or dissemination of alternative information sources (e.g., Gigler and Hemmer, 2001), then again the researcher faces an omitted correlated variables problem. 6 Ball, Robin, and Wu (2003) emphasize the benefits of their sample – within East Asia – to mitigate the concern that cross-country variation in ERCs reflects variation in the return generating process rather than differences in earnings quality. 13
Proxies for asymmetric timeliness based on the tendency of accruals to reverse avoid the above noted problems associated with returns-based metrics. (Section 3.1.3 discusses these metrics, proposed by Basu, 1997, and implemented in studies such as Ball and Shivakumar, 2005.) Similar to the concern raised about accruals models, this attempt to control for the fundamental earnings process is based on reported accrual-based earnings associated with the process (growth in sales revenue, for example). Benchmarking (Section 3.1.4): The benchmarking studies use small positive differences between reported earnings and any benchmark as a measure of earnings quality. This literature includes studies that examine the “kink” in the distribution of reported earnings around zero (e.g., Burgstahler and Dichev, 1997), as well as studies of firms that report small positive profits or avoid small losses, or “meet or beat” forecasts. A common but controversial interpretation of the kink in the earnings distribution around zero is that firms with small (unmanaged) losses intentionally manage earnings just enough to report a small profit. The evidence on whether the kink in earnings around zero implies that small profits likely contain a managed component is mixed at best. The relation between small profits and earnings management proxies is supported mostly in accrual-specific studies. Taken together, these results suggest that the use of small profits as a proxy for earnings management is setting-specific and not generalizable. Evidence that earnings are likely managed when firms just meet or beat an external target is more persuasive. An important caveat to this evidence is that firms that are constrained in their ability to manage earnings may not meet or beat a target (Barton and Simko, 2002). Thus, meeting 14
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Page 57 and 58: earnings quality. The studies speci
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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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