Understanding earnings quality - MIT Sloan School of Management

More documents

Recommendations

Info

or beating a target represents a censored measure of earnings management. In addition, the analyst forecast target can also be managed. The evidence on the quarterly patterns in earnings distributions are somewhat conflicting. Kerstein and Rai (2007) and Jacob and Jorgensen (2007) find that the kink in earnings around zero is strongest in the fourth quarter. Both papers emphasize their finding as evidence that the kink implies earnings management because the incentives to manage earnings are greatest in Q4. Brown and Pinello (2007), however, find that avoiding small negative analyst forecast errors is strongest in interim quarters. They emphasize their result as evidence of greater earnings management in interim quarters when the opportunities are greatest. The first two studies examine small profit firms while Brown and Pinello (2007) examine firms that avoid missing analyst forecast targets. Differences in the incentives and opportunities to meet these targets may explain the seemingly conflicting results. 2.2.2 Earnings response coefficients (Section 3.2) Liu and Thomas (2000) conclude that the ERC can be viewed as a measure of higher quality earnings (p. 73) based on the finding that the observed ERC will be high when the correlation between unexpected earnings and forecast revisions is high. Their conclusion about the ERC as a proxy for earnings quality is in the sense of Graham and Dodd (1934) in that a higher ERC is associated with predictability of the fundamental earnings process. However, researchers should not take the Liu and Thomas (2000) conclusion out of their context and assume they can use the ERC, or the R 2 from the ERC regression, as a proxy for quality in any context. Liu and Thomas (2000) indicate, for example, that the degree to which the ERC captures quality is sensitive to the degree of heterogeneity of the correlation between unexpected earnings and forecast revisions within the 15
sample. Hence, sample specific characteristics that affect within-sample heterogeneity, such as growth, are important. For three reasons, researchers must be cautious when using the ex post observed ERC (or the regression R 2 ) as a proxy for ex ante earnings quality, interpreted as the ability of the financial reporting system to capture relevant economic activities. First, because of the relation between earnings quality and voluntary disclosure, the observed ERC does not reflect the cross-sectional variation in ex ante earnings quality. This same criticism was discussed for asymmetric timeliness and returns-based metrics in general. Second, the prediction that a more precise earnings report will yield higher ERCs (Holthausen and Verrecchia, 1988) does not anticipate sources of variation in investor estimates of precision unrelated to the earnings number, such as the heightened uncertainty during a proxy contest (Collins and DeAngelo, 1990) or variation in the ability of equity markets to assess quality (i.e., markets are not equally efficient). Finally, returns, which are the other element of ERCs besides earnings, can exhibit cross-sectional and time-series variation (Johnson, 1999; Hoitash, Krishnan, and Sankaraguruswamy, 2002). Hence, ERCs may work as a proxy for earnings quality in a differences-in-differences analysis that can control for these alternative sources of variation in the ERCs, but these problems generally pose significant challenges in most research settings/designs. 2.2.3 External indicators of financial reporting quality (Section 3.3) Studies using AAERs, restatements, and SOX internal control deficiency reports as proxies for earnings quality help to validate various proxies for earnings quality. They are also a useful setting to validate the theoretical determinants and consequences of quality that are investigated in other contexts. Each sample, however, has limitations as a measure of earnings quality, in general, 16
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: Proxies for asymmetric timeliness b
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 and 140:
the fact that some disclosures are
Page 141 and 142:
Therefore, the proxies are not meas
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?