Understanding earnings quality - MIT Sloan School of Management

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examine both determinants (i.e., governance) and consequences (i.e., future performance) of earnings management to disentangle two alternative explanations for earnings management: unexpected managerial opportunism versus efficient contracting. Their “complete path” approach offers insights that are not available from studies that examine only one side (i.e., determinant or consequence) of earnings quality. In other words, external auditors and internal controls may both affect abnormal accruals, and abnormal accruals may affect the cost of capital, but is the impact of accruals on the cost of capital the same when the source is external auditors rather than controls? Other good examples are Xie (2001) and Liu and Thomas (2000). (10) Our survey indicates a number of inconsistencies in the tests of the determinants or consequences of earnings quality. (Figures 1 and 2 reveal these inconsistencies.) We highlight several in the following table: Research question Yes No Does incentive equity compensation provide incentives to manipulate earnings? Efendi et al., 2007 Armstrong et al., 2009 Is better corporate governance associated with higher earnings quality? Klein, 2002 Larcker et al., 2007 Does nonaudit service compromise audit quality? Frankel et al., 2002 Ashbaugh et al., 2003 Are SOX 404 disclosures informative to investors? Ashbagh-Skaife et al., 2009 Does managerial opportunism or efficient contracting drive earnings management? 25 Becker et al., 1998 (opportunism) Ogneva et al., 2007 Bowen et al., 2008 (efficient contracting) As shown in Figures 1 and 2, studies that examine a particular consequence or determinant frequently use the same EQ proxy, so it is not differences in the quality proxy that lead to these mixed results. A significant source of the differences appears to be differences in sample or
methodology. Studies could make unique predictions across proxies. The predictions may be in degrees: determinant X is predicted to have a stronger impact on quality proxy Y than on Z. Or, the tests may be designed to assess divergent validity (i.e., counterfactual examples): determinant X is predicted to be associated with quality proxy Y but not with Z. A greater focus on stronger identification strategies in research designs could help sort out the mixed evidence given the various methodological issues associated with distinguishing the fundamental component of earnings quality from the process. 3. Proxies for earnings quality This section juxtaposes the studies according to the proxy they use for earnings quality (see Table 1, Panel A). We define three categories of proxies: 1) Properties of earnings; 2) Earnings response coefficients (ERCs); and 3) External indicators of financial reporting quality (FRQ). 3.1 Properties of earnings We distinguish four groups of earnings properties: Persistence, asymmetric timeliness and timely loss recognition, smoothness of earnings, and “benchmarking.” Section 3.1.1 discusses research that examines the persistence of earnings and accrual models. Studies that use the term predictability and examine earnings usefulness to predict future cash flows are included in this section as well. Section 3.1.2.examines research on earnings smoothness and variability. The benchmarking category (Section 3.1.4) includes measures of earnings relative to any benchmark. 26
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
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Page 11 and 12: accruals, in total or individually,
Page 13 and 14: While we identify these contradicti
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Page 17 and 18: sample. Hence, sample specific char
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Page 21 and 22: Empirical studies have examined mul
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Page 25: is primarily driven by the firm’s
Page 29 and 30: The discussion of earnings persiste
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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
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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
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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
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Page 71 and 72: significantly change the historical
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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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