Understanding earnings quality - MIT Sloan School of Management

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Figure 4: Construct validity across earnings quality proxies The links shown in this figure provide a graphical representation of proxies that have been validated using other proxies in papers within our database. 169
Table 1. Categories of “Earnings quality” proxies, determinants of EQ, and consequences of EQ This table outlines the sub-categories of the three categories of earnings quality proxies, the six categories of determinants of earnings quality, and the two categories of consequences of earnings quality. For each, we report the section number in this document in which the item is discussed. Panel A: Earnings quality proxies Panel B: Determinants of EQ 170 Panel C: Consequences of EQ Property of earnings 3.1 Firm characteristics 5.1 Capital markets 6.1 Persistence and accruals 3.1.1 Performance and losses 5.1.1 Returns 6.1.1 Smoothness 3.1.2 Growth and investment 5.1.2 Market valuations 6.1.2 Asymmetric timeliness and Debt, capital structure 5.1.3 Cost of equity capital 6.1.3 timely loss recognition 3.1.3 Size 5.1.4 Debt pricing 6.1.4 Benchmarking 3.1.4 Financial reporting practices 5.2 Non-equity market consequences Earnings response coefficients 3.2 Litigation 6.2.1 Accounting methods and ERCs 3.2.1 Governance and controls 5.3 Compensation 6.2.2 Firm characteristics and ERCs 3.2.2 Board of directors 5.3.1 Executive turnover 6.2.3 Information environment and ERCs 3.2.3 Internal control procedures 5.3.2 Audit opinions 6.2.4 Managerial ownership 5.3.3 Analyst decisions 6.2.5 External indicators of financial Compensation 5.3.4 Real activities 6.2.6 reporting quality 3.3 Manager change 5.3.5 AAERs 3.3.1 Restatements 3.3.2 Auditors 5.4 Internal control procedures 3.3.3 Auditor size 5.4.1 Auditor fees 5.4.2 Other auditor characteristics 5.4.3 Capital market incentives 5.5 When raising capital 5.5.1 Earnings-based targets 5.5.2 External factors 5.6 Political process 5.6.1 Capital regulations 5.6.2 Tax regulations 5.6.3 SOX 5.6.4
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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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(Jones, 1991); 2) Department of Jus
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5.6.3 Tax regulations Several studi
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Page 121 and 122: attention (Aboody et al. , 1999). 7
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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
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: Figure 3: Key links between determi
Page 173 and 174: Exhibit 1: Summary of earnings qual
Page 175: Exhibit 2: Summary of widely used m
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