Understanding earnings quality - MIT Sloan School of Management

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and Melumad (2002) similarly emphasize the important trade-off between reporting high “real” levels of income, which are suggested to be more informative, and earnings smoothness. (3) A consistent finding across studies that test a variety of theories in different settings and using different proxies for EQ is that when investors are able to observe, or rationally infer, increased estimation error (intentional or unintentional), they internalize its effect on price. Therefore, where the manipulation is more transparent or where the incentives are more obvious, investors will anticipate and discount potential earnings management or accounting distortions. Numerous examples support this statement. For example, investors discount upward earnings management when banks are highly levered and close to capital market constraints. Investors discount downward earnings management when they are aware that managers will be issued with repriced options. Investors discount the discretionary accrual component of earnings when information on accruals is disclosed at the earnings release. Investors in the property and casualty insurance industry understand and correctly price the accrual related to future payouts because there are extensive disclosures related to this accrual’s errors and corrections. Meeting or beating analyst forecasts on an ad hoc basis does not lead to higher valuations, but meeting or beating regularly does. See additional examples in the discussion of equity market consequences in Section 3.1.1.5. (4) Taken together, the previous two observations – that firms might tailor accounting mechanism choices to specific earnings objectives and that equity investors can rationally infer or observe earnings management – suggests predictable patterns in the portfolio of a firm’s accounting choices. If firms want to influence debt contracting outcomes but not at the expense of their cost of equity, 21
there are (in theory) predictable accounting choices that can meet both objectives. For example, in a world of imperfect debt contracting, many types of gains can prevent covenant violation, but if they are made transparent, equity investors can undo their effect on earnings and they will not affect “information quality.” This observation represents a research opportunity, but it also suggests that it is difficult to interpret the evidence of studies that focus on only one determinant of an accounting choice. Recognizing that the single reported earnings number is the outcome of a complicated number of choices, motivated by multiple incentives, has implications for understanding the consequences of earnings quality. If equityholders understand a firm’s incentives for reporting earnings, and if they understand its constraint to report only one earnings number, and if they have the ability to interpret reported earnings and/or to substitute other information for reported earnings, then we may not observe positive market responses to earnings that are of high quality with respect to equity valuation decisions. In fact, equity markets might respond negatively to firms that do not report a number that maximizes firm value, even if it distorts the ability of earnings to capture the firm’s fundamental earnings process. In contrast, if equityholders do not recognize the earnings management to meet non-equity market objectives, accounting choices will have a spillover effect to the equity markets. Studies of accounting choice generally do not emphasize the trade-off between the short-term benefits of opportunistic accounting choices at the time of an event (e.g., an IPO) and the potential long-term reputation loss due to these one-off earnings management decisions. (5) As noted previously, the determinants and consequences of abnormal accruals have received the most attention. The literature tends to validate accruals models by showing that the abnormal accrual is correlated with hypothesized predicted determinants or consequence of abnormal accruals. 22
Page 1 and 2: *Title Page/Author Identifier Page/
Page 3 and 4: Street equity valuation model as ea
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: Empirical studies have examined mul
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
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
Page 59 and 60: to conservatism, which is defined a
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
Page 69 and 70: ange of misstatements and they are
Page 71 and 72: 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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