Understanding earnings quality - MIT Sloan School of Management

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Table 2. Spearman correlations between earnings quality proxies (Sample period: 1987-2007) Table 2 reports the spearman correlation coefficients between commonly used specifications of earnings quality proxies, as defined in Exhibit 1. Persistence is measured as the estimated β in the firm-level regression: Earningst+1=α+ βEarningst + εt. Total accruals is defined as the difference between earnings and cash flows from operations. |Accruals| is the absolute value of Total accruals. Estimation errors is defined as the firm-level mean absolute value of the residual from ∆WC =α+β1CFOt-1 +β2CFOt+ β3CFOt+1+εt. σ(residual) is the firm-level standard deviation of the residual from the above regression. σ (EARN)/σ (CFO) is the firm-level standard deviation of earnings divided by the standard deviation of cash flow from operations. Corr(ΔACC,ΔCFO) is the firm-level correlation between change in total accruals and change in cash flow from operations. Timely loss recognition is defined as (β1+β2)/β1 from the firm-level regression: Earningst+1=α1+α2Dt+β1Rett+β2Dt·Rett +εt where D=1 if Ret
Exhibit 1: Summary of earnings quality proxies This exhibit lists the commonly used proxies for earnings quality and the most common specification(s) of the variable. The exact specification of the proxies can vary by study. For each, we summarize the theory for its use as a measure of quality and an abbreviated summary of the strengths and weaknesses of the proxy. Details are in the review in Section 3. Empirical proxy Theory Strengths and weakness Persistence Earningst+1=α+ βEarningst + εt β measures persistence. Smoothness σ(Earnings)/ σ(Cash flows) A lower ratio indicates more smoothing of the earnings stream relative to cash flows. Timely loss recognition (TLR) Earningst+1=α0+α1Dt+β0Rett +β1DtRett +εt where D = 1 if Ret < 0. Higher β1 is greater TLR. Benchmarks ∗ Kinks in earnings distribution ∗ Changes in earnings distribution ∗ Kinks in forecast error distribution ∗ String of positive earnings increases Firms with more persistent earnings generate more accurate DCF-based equity valuations. Managers opportunistically smooth earnings. Therefore, greater smoothness is artificial relative to the fundamental process; or, smoothness reduces noisy variation in cash flows as a measure of the process. There is a demand for TLR to combat management’s natural optimism. TLR represents high quality earnings. Unusual clustering in earnings distributions indicates earnings management around targets. Observations at or slightly above targets have low quality earnings. 172 Pros: Fits well with a Graham and Dodd view of earnings as a summary metric of expected cash flows useful for equity valuation. Cons: Difficult to control for persistence of the fundamental earnings process, but this persistence is likely to be a large contributor to persistence of reported earnings. Thus, it is difficult to make statements about the effect of measurement on persistence. Greater persistence may be achieved via opportunistic earnings management. Pros: In cross-country tests, measures of artificial smoothness appear to capture meaningful variation in earnings management. Cons: It is difficult to disentangle smoothness of reported earnings that reflects smoothness of the fundamental earning process from artificial smoothing. Pros: Aimed at disentangling the measurement of the process from the process itself. Cons: The net effect of TLR on earnings quality is unknown because TLR results in lower persistence during bad news periods than during good news periods (Basu, 1997). Both persistence and TLR affect the decision usefulness of earnings. TLR is a returns-based metric, see comments on ERCs. Pros: The measure is easy to calculate, the concept is intuitively appealing, and survey evidence suggests earnings management around targets. Cons: In addition to statistical validity issues, evidence that kinks represent opportunistic earnings management is mixed, with credible alternative explanations including non-accounting issues (e.g., taxes). It is difficult to distinguish firms that are at kinks by chance versus those that have manipulated their way into the benchmark bins.
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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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importance of implicit claims, they
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Page 171: Table 1. Categories of “Earnings
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