Understanding earnings quality - MIT Sloan School of Management

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*Manuscript Understanding earnings quality: A review of the proxies, their determinants and their consequences We begin with a definition of “earnings quality” that sets the scope of our review. Higher quality earnings more faithfully represent the features of the firm’s fundamental earnings process that are relevant to a specific decision made by a specific decision-maker. Our definition implies that the term “earnings quality” is meaningless without specifying the decision context, because the relevant features of the firm’s fundamental earnings process differ across decisions and decision makers. Consistent with this broad definition, we review approximately 350 published papers on earnings. 1 We do not require that the researcher use the term earnings quality. This broad scope is motivated by the varied and often imprecise use of the term “earnings quality” by practitioners (including regulators, enforcement agencies, and courts), the financial press, and academic researchers. Lev (1989) popularized the adjective “quality” as a descriptive characteristic of earnings for academic researchers when he stated that one explanation for low R 2 s in earnings/returns models is that: “No serious attempt is being made to question the quality of the reported earnings numbers prior to correlating them with returns.” Lev’s statement implicitly suggests that he defines earnings quality as decision-usefulness in the context of equity valuation decisions. This use of the term “quality” is consistent with O’Glove’s practitioner-oriented financial statement analysis textbook, Quality of Earnings, published in 1987, and even with Graham and Dodd’s use of the term in Security Analysis, published in 1934. Graham and Dodd describe the Wall 1 We searched four journals starting with the first issue (in parentheses) through 2008: Contemporary Accounting Research (1984), Journal of Accounting and Economics (1980), Journal of Accounting Research (1964), and Review of Accounting Studies (1996). We searched The Accounting Review from 1970 through 2008. We added articles from other journals and working papers to the extent we are aware of them, but we did not perform a systematic review to find them. 1
Street equity valuation model as earnings per share times a “coefficient of quality” where the quality coefficient reflects firm-specific characteristics such as dividend policy, as well as “size, reputation, financial position and prospects,” the nature of the firm’s operations, and macro factors including “temper of the general market.” Accounting researchers continue to use the descriptor quality in reference to the decision-usefulness of earnings in equity market valuation, but use of the term has been extended to other contexts as well, likely because of our conversational understanding of the term quality as an indication of superiority or excellence. This evolution of a term such as earnings quality to its current state of ambiguity is not unique. Schelling (1978) describes the phenomenon: Each academic profession can study the development of its own language. Some terms catch on and some don’t. A hastily chosen term that helps meet a need gets initiated into the language before anybody notices what an inappropriate term it is. People who recognize that a term is a poor one use it anyway in a hurry to save thinking of a better one, and in collective laziness we let inappropriate terminology into our language by default. Terms that once had accurate meanings become popular, become carelessly used, and cease to communicate with accuracy. Our approach in this review is to embrace the fact that earnings quality is a multi-faceted term. We therefore expand the scope of the review beyond studies of the decision-usefulness of earnings in an equity valuation context. We identify the various proxies that have been used to measure earnings quality, evaluate the various attributes of decision usefulness (i.e., “quality”) that researchers have measured, and point out the strengths and weaknesses of each measure. We also identify circumstances where researchers obtain conflicting results because of ambiguity in what is meant by “quality” or differences due to the choice of earnings quality proxy. 2 2 A number of survey papers of earnings quality and/or earnings management predate this review: Healy and Wahlen (1999); Dechow and Skinner (2000); McNichols (2000); Fields, Lys, and Vincent (2001); Imhoff (2003); Penman (2003); Nelson, Elliott, and Tarpley (2003); Schipper and Vincent (2003); Dechow and Schrand (2004); Francis, Olsson, 2
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Page 5 and 6: earnings quality proxy is the indep
Page 7 and 8: of fundamental earnings will be a f
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 and 18: sample. Hence, sample specific char
Page 19 and 20: unintentional misstatements, which
Page 21 and 22: Empirical studies have examined mul
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
Page 39 and 40: measurement. Nwaeze, Yang, and Yin
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
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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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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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