Understanding earnings quality - MIT Sloan School of Management

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Exhibit 1, continued Empirical proxy Theory Strengths and weakness Accruals Accruals= Earningst - CFt Accruals=Δ(noncash working capital) Accruals= Δ(net operating assets) Specific accrual components Residuals from accrual models Error term from regressing accruals on their economic drivers (See Exhibit 2) ERCs Rett+1= α+β(EarningsSurpriset)+εt More informative components of earnings will have a higher β. More value relevant earnings will have a higher R 2 . External indicators of financial reporting quality ∗ AAERs identified by SEC ∗ Restatements ∗ SOX reports of internal control deficiencies Extreme accruals are low quality because they represent a less persistent component of earnings. Residuals from accrual models represent management discretion or estimation errors, both of which reduce decision usefulness. Investors respond to information that has value implications. A higher correlation with value implies that earnings better reflect the fundamental earnings process. Firms had errors (AAERs and restatement firms) or are likely to have had errors (internal control deficiencies) in their financial reporting systems, which imply low quality. 173 Pros: The measure gets directly at the role of an accruals-based accounting system relative to a cash-flow based system. Cons: The fundamental earnings process differs for firms with extreme accruals versus less extreme accruals, which hinders interpretation. Pros: The measure attempts to isolate the managed or error component of accruals. The use of these models has become the accepted methodology in accounting to capture discretion. Cons: Tests of the determinants/consequences of earnings management are joint tests of the theory and the abnormal accrual metric as a proxy for earnings management. Correlated omitted variables associated with fundamentals, especially performance, are of utmost concern given the dependence of normal accruals on fundamentals and the endogeneity of the hypothesized determinants/consequences with the fundamentals. Pros: The measure directly links earnings to decision usefulness, which is quality, albeit specifically in the context of equity valuation decisions. Cons: Assumes market efficiency. In addition, inferences are impaired by correlated omitted variables that affect investor reaction (including endogenously determined availability of other information), measurement error of unexpected earnings, and cross-sectional variation in returngenerating processes. Pros: Unambiguously reflect accounting measurement problems (low Type I error rate). The researcher does not have to use a model to identify low quality firms. Cons: For AAERs: small sample sizes, selection issues, and matching problems due to type II error rate. For restatements and SOX firms: problems with distinguishing intentional from unintentional errors or ambiguities in accounting rules that lead to errors.
Exhibit 2: Summary of widely used models of accruals This table summarizes commonly used models to estimate normal levels of accruals. Residuals from the model are used as a measure of “abnormal” accruals. Accrual model Theory Notes Jones (1991) model Acct=α+β1�Revt+β2PPEt+εt Modified Jones model (Dechow, Sloan and Sweeney, 1995) Acct=α+β1(�Revt - �Rect) +β2PPEt+εt Performance matched (Kothari, Leone, and Wasley, 2005) DisAcct - Matched firm’s DisAcct Dechow and Dichev (2002) approach �WC =α+β1CFOt-1+β2CFOt+ β3CFOt+1+εt Accruals are a function of revenue growth and depreciation is a function of PPE. All variables are scaled by total assets. Adjusts Jones model to exclude growth in credit sales in years identified as manipulation years. Matches firm-year observation with another from the same industry and year with the closest ROA. Discretionary accruals are from the Jones-model (or Modified Jones model). Accruals are modeled as a function of past, present, and future cash flows given their purpose to alter the timing of cash flow recognition in earnings. Discretionary estimation errors (Francis, LaFond, Olsson, Schipper, 2005) TCAt=α+β1CFOt-1+ β2CFOt + β3CFOt+1+β4�Revt+β5PPEt+εt σ(εt)=α+λ1Sizet+λ2σ(CFO)t+λ3σ(Rev)t+ λ4log(OperCycle)t+λ5Losst+νt Decomposes the standard deviation of the residual from the accruals model into an innate component that reflects the firm’s operating environment and a discretionary component (νt) that reflects managerial choice. 174 Correlation or error with firm performance can bias tests. R 2 around 12%. Residual is correlated with accruals, earnings and cash flow. Can reduce power of test. Apply only when performance is an issue. σ(εt) or absolute εt proxies for accrual quality as an unsigned measure of extent of accrual “errors.” Innate estimation errors are the predicted component from σ(ε)t regression.
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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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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 141 and 142: Therefore, the proxies are not meas
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Page 145 and 146: Beasley, M., 1996. An empirical ana
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Page 149 and 150: Considine, J., Mensah, Y., Oakes, L
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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
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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: Exhibit 1: Summary of earnings qual
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