Understanding earnings quality - MIT Sloan School of Management

or of earnings management. The AAER sample includes earnings management cases that are
typically outside of GAAP and are identified by the SEC. This sample is likely to contain only the
most egregious misstatements and excludes many firms that are likely to be managing earnings. The
restatement sample includes some immaterial misstatements, corrections of unintentional errors, and
applications of some new pronouncements (e.g., SAB 101 required retroactive restatement). The
sample of firms that disclose internal control deficiencies could be affected by manager and auditor
incentives to discover and disclose the weaknesses. The restatement sample offers an opportunity to
explore variation in the implications of unintentional versus intentional misstatements in various
decision-making contexts, although that variation has not been exploited, with the exception of
Hennes, Leone, and Miller (2008).
The relation between internal control procedures and external auditors is not adequately
explored. An exception is Hogan and Wilkins (2008), who document that audit fees in the year
prior to the disclosure of an internal control deficiency are higher than the fees for a matched sample
that does not report deficiencies. One explanation for this finding is that auditors charge higher fees
for the extra audit effort required to audit firms with weak controls. In this case, we would observe
an association between fees and weak internal controls, but not necessarily between fees and
earnings quality. Another explanation is that auditors charge higher fees when the assessed audit
risk is higher, and weak controls are correlated with audit risk assessments (i.e., the fees represent a
pure risk premium). In this case, we would observe a relation between internal controls and earnings
quality. Hogan and Wilkins emphasize the second explanation while admitting that they cannot rule
out the risk premium story.
The studies that investigate the determinants and consequences of the external indicators of
financial reporting quality emphasize the incentives and opportunities for intentional and
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