Understanding earnings quality - MIT Sloan School of Management

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
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