Understanding earnings quality - MIT Sloan School of Management

More documents

Recommendations

Info

depress current earnings but lead to future improvements in earnings. An increase in financial leverage, however, tends to have an incrementally negative effect on future earnings (scaled by equity). Fairfield, Whisenant, and Yohn (2003a) suggest that growth and conservatism in accruals could be determinants of the lower persistence of the accrual component of earnings. They show that the change in PPE has similar implications for persistence as working capital accruals. However, the measurement of PPE is itself a product of the accrual accounting system and the growth in this variable could also reflect accounting measurement problems (see Zhang, 2007). Richardson et al. (2005) further investigate growth. They decompose the change in net operating assets (total accruals) into a growth component (proxied by sales growth) and an efficiency component (net operating asset turnover ratio) and an interaction effect. They show that declines in efficiency and growth both play a role in the lower persistence of the accrual component. While their paper suggests that growth is not a complete explanation for the low persistence parameter on accruals, it suffers from the same criticism that sales growth, as a proxy for growth, is itself a product of the accrual accounting system. Researchers have also attempted to directly examine whether forecast errors made by management (that will affect the magnitude of accruals) and their subsequent corrections have implications for earnings persistence. Dechow and Dichev (2002) develop a measure of accrual quality based on accruals modeled as a function of past, present, and future cash flows (discussed later in this section). Holding the magnitude of accruals constant, earnings persistence is negatively associated with the Dechow/Dichev accruals quality measure. In contrast, holding the accruals quality measure constant, the association between persistence and the magnitude of accruals is much weaker. 33
Xie (2001) uses the Jones model (discussed later in this section) to decompose accruals into a normal and abnormal component. The abnormal component is likely to contain more measurement error and managerial discretion. He finds the persistence parameters on cash flows, normal accruals, and discretionary accruals are 0.73, 0.7, and 0.57. This result indicates that discretionary accruals are less persistent than either normal accruals or cash flows, consistent with reliability and measurement issue concerns. Richardson et al. (2005) develop a model of reliability and argue that operating assets and liabilities are less reliably measured than financial assets and liabilities. Consistent with their predictions, they find that working capital (operating) accruals have the lowest reliability, accruals related to financial assets and liability have the highest, and long-term operating accruals are in the middle. Broadly speaking, they find a positive relation between their ex ante reliability rankings and return on assets. Internal control violations under the Sarbanes Oxley act are suggestive of measurement error and problems with the accounting system. Doyle, Ge, and McVay (2007a) find that firms that disclose they have at least one material weakness during the 2002-2005 period, have less persistent earnings. Finally, Wang (2006) finds a positive association between founding family ownership and proxies for accrual quality and earnings persistence. 3.1.1.4 Consequences of persistence The vast majority of papers on consequences of persistence examine equity market consequences. A few papers discuss consequences that we refer to collectively as other-than-equity- market consequences. Equity market consequences: Researchers hypothesize two distinct equity market consequences of persistence. The first prediction is that more persistent earnings will yield a higher equity market 34
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
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: 1993). 12 The studies find conflict
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

Create successful ePaper yourself

Delete template?

Save as template?