Understanding earnings quality - MIT Sloan School of Management

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Figure 1. Summary of the investigated determinants of earnings quality Figure 1 summarizes the explanatory variables for (“determinants” of) the various earnings quality proxies. The rows represent the most frequently hypothesized determinants of earnings quality and correspond to the organization of the discussion in Sections 5.1 through 5.6. The columns represent our categories of commonly used earnings quality proxies. A shaded box indicates that researchers have investigated whether the determinant explains variation in the earnings quality proxy. The first number in a shaded box indicates the number of papers in our database that examine the association between a determinant and an EQ proxy. The second number in a shaded box (if there is one) indicates the number of papers that provide negative evidence (inconsistent with the theory). Determinant Persistence and accrual attributes Abnormal accruals 165 Earnings quality proxy Properties of earnings ERCs Smoothness Asymmetric timeliness/ Timely loss recognition Benchmarking (loss avoidance) Benchmarking (small positive earnings surprise) Investor response coefficients External indicators of financial reporting quality Firm characteristics Firm performance 1 5/2 2/1 1 2 2 Firm growth Financial statement 6 1 1 1/1 2 components 10 1 3 10 2 1 Firm size 1 1 1 2 Firm debt covenant 2/1 3/2 2 Debt as a call option 3 Financial reporting practices Accounting methods Other financial reporting 4 1 6 practices 1 2 2 Principles based versus rules based methods 1 1 1 1 AAERs Restatements Internal control procedures
Figure 1. Summary of the investigated determinants of earnings quality, continued Persistence and accrual attributes Abnormal accruals 166 Earnings quality proxy Properties of earnings ERCs Smoothness Asymmetric timeliness/ Timely loss recognition Benchmarking (loss avoidance) Benchmarking (small positive earnings surprise) Investor response coefficients External indicators of financial reporting quality Determinant Governance and controls Board characteristics 3/1 1 1 2 4 2/1 1 I/C procedures 1 2 1 Managerial ownership 4/1 1 1 3 1/1 Earnings-based comp. 4/2 2/2 Equity compensation 5 1 4/2 4/2 Managerial change 2 Auditors Auditor size 2/1 4 1 1/1 1/1 Auditor fees 3/1 Non-audit fees 6/3 1/1 1 2 2/1 Other auditor-related 7/2 1/1 1/1 Capital market incentives IPO and SEO 1 8/1 2 1 Mergers buyout 3/1 Cross-listing 2 1 1 1 1 Incentives to meet earnings-based targets 3 3/1 External factors Political process 8 Capital regulations 5 Tax regulations 7/2 SOX 2 Country-level institutional factors 1 2 2 4 4 5 AAERs Restatements Internal control procedures
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*Title Page/Author Identifier Page/
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Street equity valuation model as ea
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earnings quality proxy is the indep
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of fundamental earnings will be a f
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contributions of the fundamental co
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accruals, in total or individually,
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While we identify these contradicti
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Proxies for asymmetric timeliness b
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sample. Hence, sample specific char
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unintentional misstatements, which
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Empirical studies have examined mul
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there are (in theory) predictable a
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is primarily driven by the firm’s
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methodology. Studies could make uni
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The discussion of earnings persiste
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and documents that β2 < β1, which
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1993). 12 The studies find conflict
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Xie (2001) uses the Jones model (di
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sophisticated investors do understa
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measurement. Nwaeze, Yang, and Yin
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and better reflects revenue manipul
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All of the accruals models can be e
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Second, investors seem to recognize
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fact improve predictability relativ
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lower book values of assets (higher
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than code law countries. The differ
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explain the kink. Durtschi and East
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with overstated net asset values ar
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earnings quality. The studies speci
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to conservatism, which is defined a
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they assert proxy for lower indepen
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paper, however, finds that firms ar
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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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Page 117 and 118: 5.6.3 Tax regulations Several studi
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Page 131 and 132: 6.1.5 Summary To summarize, the evi
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Page 135 and 136: income increasing restatement firms
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Page 141 and 142: Therefore, the proxies are not meas
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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: Tucker, J., Zarowin, P., 2006. Does
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
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