Understanding earnings quality - MIT Sloan School of Management

Other studies attempt to validate discretionary accruals from accruals models using external
indicators of financial reporting quality such as restatements, SEC enforcement actions, and SOX
internal control deficiency reports. The type II error rate in these samples, however, is extremely
high (most high discretionary accrual firms are not members of these samples). Therefore, positive
correlations are supportive evidence but far from conclusive.
Few papers, however, validate the accruals models by examining the “normal” component of
accruals. Our understanding of earnings quality would benefit from more direct evidence on how an
imperfect measurement system, when applied without intentional bias, distorts the measurement of a
firm’s fundamental earnings process. Examples of research along these lines include Landsman and
Shakespeare (2005) who put securitizations back on the balance sheet; Lev and Sougiannis (1996)
who capitalizes and expenses R&D; Ge (2007) who capitalizes operating leases; and Dutta and
Reichelstein (2005) who provide theoretical work on optimal capitalization policies.
(6) While it has long been recognized that accounting choices can be motivated by opportunism or
efficient contracting, we still do not have sufficient evidence on this issue (see Christie and
Zimmerman, 1994, Bowen et al., 2008). Again, the issue of multiple objectives arises, because a
single accounting choice may appear opportunistic if hypothesized to be related to one objective,
while the inference is invalid when allowing firms to have multiple objectives but constraining them
to choose only one earnings number. This issue was raised in studies that use properties of earnings,
accruals, and ERCs as proxies for EQ, yet the research is inconclusive.
(7) We are not aware of studies about a firm’s earnings-related accounting choices when the
anticipated impact of the choice on earnings properties is expected to be limited because the property
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