Understanding earnings quality - MIT Sloan School of Management

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,
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