Understanding earnings quality - MIT Sloan School of Management

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disaggregates the working capital and other accrual components of earnings results in lower cash flow forecast errors and improved predictability (Dechow, Kothari, and Watts, 1998; Barth et al., 2001). 9 3.1.1.2 The usefulness of earnings to predict future earnings Research that characterizes the persistence of earnings is motivated by the assumption that more persistent earnings will yield better inputs to equity valuation models. A simple model specification estimates earnings persistence as: Earningst+1=α+β1Earningst+εt Researcher can add other financial statements elements or variables outside the financial statements (e.g., market based measures or disclosures from the footnotes) to examine to examine their incremental explanatory power to predict future earnings: Earningst+1=α+β1Earningst+β2components of financial statements or other informationt + εt If β2 is significant in either direction, then the researcher has identified a determinant of future earnings that provides incremental information beyond current earnings. Alternatively, researchers can decompose earnings into its components and examine whether the components have different implications for future earnings. For example, Sloan (1996) examines two components of earnings: Earningst+1=α+β1CFt+β2Accrualst+εt 9 Some studies use this framework, measuring relative predictive ability, but model future earnings. These studies consistently find that special items as a subset of accruals do not improve the ability of accrual earnings to predict future earnings relative to cash based earnings (e.g., Barth et al., 2001; Dechow and Ge, 2006). Other studies model contemporaneous stock returns (Ball and Brown 1968, Dechow 1994) or market value (Penman and Sourgiannis 1998). Stock based measures generally find that accruals help improve earnings ability to reflect value (except if earnings includes large write-downs or special items). 29
and documents that β2 < β1, which implies that the cash flow component of earnings is more persistent than the accrual component. As noted in the introduction, reported earnings represents the firm’s fundamental earnings process (X) and the measurement of that process (e). Thus, when researchers add financial statement ratios to the incremental predictability model above, the ratios they add are generally computed using reported accounting numbers. Thus, they do not disentangle the unobservable fundamental earnings process (X) from the measurement of the process. Likewise, any decomposition of accruals into its components decomposes them based on their reported amounts. Clearly, we recognize the constraint that researchers face when they attempt to measure an unobservable construct like the fundamental earnings process. By highlighting this issue, we hope that researchers can search for better instruments than reported numbers to capture the effects of the persistence of “X” on the persistence of earnings. 3.1.1.3 Determinants of persistence This section discusses studies 1) that model the incremental explanatory power of variables over current earnings for future earnings, and 2) that document the predictive ability of earnings components as determinants of persistence. While it was just noted that predictability of future earnings is likely to be driven to a large extent by the business in which the firm operates, there is little work that uses the approach above to test for such determinants. Lev (1983) associates persistence with product type, industry competition, capital intensity, and firm size, generally motivating these variables as proxies for uncertainty of the business process. Baginski, Lorek, Willinger, and Branson (1999) find that the relations documented in Lev (1983) are weak using persistence metrics from lower-order time series models but exist when the measure of persistence is 30
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Page 3 and 4: Street equity valuation model as ea
Page 5 and 6: earnings quality proxy is the indep
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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: The discussion of earnings persiste
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
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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
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Page 67 and 68: eadjustments in valuations associat
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Page 71 and 72: significantly change the historical
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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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