Understanding earnings quality - MIT Sloan School of Management

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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 17
unintentional misstatements, which are two of the three elements of the fraud triangle, but they do not investigate the third element: attitude. Recently, several studies have tried to examine the role of executive characteristics in financial reporting decisions, including accounting fraud (Hribar and Yang, 2007; Schrand and Zechman, 2009; Ge, Matsumoto, and Zhang, 2009). 2.3 Overview of the network and research opportunities This section summarizes ten additional research-related conclusions. 1) Some studies treat the earnings quality proxies as substitutes and test hypothesized predictions about a determinant or consequence of “earnings quality” using a proxy for earnings quality that does not appropriately measure the theoretical construct. That is, not all studies carefully register that the testable hypotheses about the determinants and consequences of earnings quality come from decision models and the models suggest a specific form of decision usefulness (i.e., earnings quality). We observe some mixed results that appear to be driven by a mismatch between the theoretical construct for decision-usefulness and the proxies. A good example is the studies of accrual quality (see Section 2.1.1.4). There is strong (mixed) [weak] evidence that internal control procedures (audit quality) [governance characteristics] affect accrual quality. The order of the strength of the evidence is consistent with the order of construct validity. Internal control procedures are meant to detect and/or prevent both the ability to manipulate earnings as well as mistakes or errors, and the accrual proxies used in these studies generally represent the types of errors that internal controls could prevent. An auditor’s responsibility, however, is only to report on whether the financial statements conform to GAAP, and the prediction that audit quality (typically measured by a proxy for independence) would be associated with abnormal accruals is less compelling. Finally, the predicted association between governance quality and accrual quality is particularly tenuous. It is not clear why some commonly used indicators of governance quality, for example 18
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Page 3 and 4: Street equity valuation model as ea
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Page 9 and 10: contributions of the fundamental co
Page 11 and 12: accruals, in total or individually,
Page 13 and 14: While we identify these contradicti
Page 15 and 16: Proxies for asymmetric timeliness b
Page 17: sample. Hence, sample specific char
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Page 23 and 24: there are (in theory) predictable a
Page 25 and 26: is primarily driven by the firm’s
Page 27 and 28: methodology. Studies could make uni
Page 29 and 30: The discussion of earnings persiste
Page 31 and 32: and documents that β2 < β1, which
Page 33 and 34: 1993). 12 The studies find conflict
Page 35 and 36: Xie (2001) uses the Jones model (di
Page 37 and 38: sophisticated investors do understa
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Page 41 and 42: and better reflects revenue manipul
Page 43 and 44: All of the accruals models can be e
Page 45 and 46: Second, investors seem to recognize
Page 47 and 48: fact improve predictability relativ
Page 49 and 50: lower book values of assets (higher
Page 51 and 52: than code law countries. The differ
Page 53 and 54: explain the kink. Durtschi and East
Page 55 and 56: with overstated net asset values ar
Page 57 and 58: earnings quality. The studies speci
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Page 61 and 62: they assert proxy for lower indepen
Page 63 and 64: paper, however, finds that firms ar
Page 65 and 66: Debt covenants: Dechow et al. (1996
Page 67 and 68: 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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of internal control procedure defic
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differences, which investors ration
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Bid-ask spread: Evidence on the ass
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low accrual quality stock that are
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6.1.5 Summary To summarize, the evi
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plaintiffs will prevail in sharehol
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income increasing restatement firms
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evisions do not fully account for t
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the fact that some disclosures are
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Therefore, the proxies are not meas
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Amir, E., Harris, T., Venuti, E., 1
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Beasley, M., 1996. An empirical ana
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Burgstahler, D., Kinney, W., Martin
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Considine, J., Mensah, Y., Oakes, L
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Desai, H., Rajgopal, S., Venkatacha
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Farber, D., 2005. Restoring trust a
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Gong, G., Louis, H., Sun, A., 2008.
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Hung, M., 2000. Accounting standard
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Kothari, S., Leone, A., Wasley, C.,
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Malmquist, D., 1990. Efficient cont
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Phillips, F., 1999. Auditor attenti
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Tucker, J., Zarowin, P., 2006. Does
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Figure 1. Summary of the investigat
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Figure 3: Key links between determi
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Table 1. Categories of “Earnings
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Exhibit 1: Summary of earnings qual
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Exhibit 2: Summary of widely used m
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