Understanding earnings quality - MIT Sloan School of Management

More documents

Recommendations

Info

*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
Page 1: *Title Page/Author Identifier Page/
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
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
Page 73 and 74:
the firm’s public accountants mus
Page 75 and 76:
whether disclosure of material weak
Page 77 and 78:
with “shareholder” corporate go
Page 79 and 80:
accruals) that stems from the confl
Page 81 and 82:
observable variables such as natura
Page 83 and 84:
and do not appear to be made to boo
Page 85 and 86:
firms identified in the AAERs than
Page 87 and 88:
past service costs). Zmijewski and
Page 89 and 90:
5.2 Financial reporting practices a
Page 91 and 92:
5.2.2 Other financial reporting pra
Page 93 and 94:
The notion that accounting method c
Page 95 and 96:
quality and the quality of M&A deci
Page 97 and 98:
In countries with high ownership co
Page 99 and 100:
for the AAER firm executives than f
Page 101 and 102:
Dechow and Sloan (1991), who study
Page 103 and 104:
management related to incentives pr
Page 105 and 106:
nonaudit fees) and discretionary ac
Page 107 and 108:
errors when litigation risk is high
Page 109 and 110:
to suffer from omitted correlated v
Page 111 and 112:
capital accruals as a proxy. Perry
Page 113 and 114:
how the incentives provided by the
Page 115 and 116:
(Jones, 1991); 2) Department of Jus
Page 117 and 118:
5.6.3 Tax regulations Several studi
Page 119 and 120:
importance of implicit claims, they
Page 121 and 122:
attention (Aboody et al. , 1999). 7
Page 123 and 124:
of internal control procedure defic
Page 125 and 126:
differences, which investors ration
Page 127 and 128:
Bid-ask spread: Evidence on the ass
Page 129 and 130:
low accrual quality stock that are
Page 131 and 132:
6.1.5 Summary To summarize, the evi
Page 133 and 134:
plaintiffs will prevail in sharehol
Page 135 and 136:
income increasing restatement firms
Page 137 and 138:
evisions do not fully account for t
Page 139 and 140:
the fact that some disclosures are
Page 141 and 142:
Therefore, the proxies are not meas
Page 143 and 144:
Amir, E., Harris, T., Venuti, E., 1
Page 145 and 146:
Beasley, M., 1996. An empirical ana
Page 147 and 148:
Burgstahler, D., Kinney, W., Martin
Page 149 and 150:
Considine, J., Mensah, Y., Oakes, L
Page 151 and 152:
Desai, H., Rajgopal, S., Venkatacha
Page 153 and 154:
Farber, D., 2005. Restoring trust a
Page 155 and 156:
Gong, G., Louis, H., Sun, A., 2008.
Page 157 and 158:
Hung, M., 2000. Accounting standard
Page 159 and 160:
Kothari, S., Leone, A., Wasley, C.,
Page 161 and 162:
Malmquist, D., 1990. Efficient cont
Page 163 and 164:
Phillips, F., 1999. Auditor attenti
Page 165 and 166:
Tucker, J., Zarowin, P., 2006. Does
Page 167 and 168:
Figure 1. Summary of the investigat
Page 169 and 170:
Figure 3: Key links between determi
Page 171 and 172:
Table 1. Categories of “Earnings
Page 173 and 174:
Exhibit 1: Summary of earnings qual
Page 175:
Exhibit 2: Summary of widely used m
show all

Understanding earnings quality - MIT Sloan School of Management

You also want an ePaper? Increase the reach of your titles

Delete template?

Save as template?